This note has been developed in preparation for the Audit and Corporate Governance Reform Bill proposed by the new Labour administration in the 2024 King’s Speech.
It focuses specifically on the matter of capital maintenance and the definition of distributable reserves, initially discussed in the BEIS Select Committee ‘Future of Audit’ report in 2019, and then in watered down form in the government’s March 2021 White Paper, ‘Restoring trust in audit and corporate governance’.
In this note we explain the significance of the capital maintenance regime, not only to the crisis in audit and accountability, but also the wider growth agenda, the ongoing challenge of State bailouts in socially necessary infrastructures and activities, and the climate crisis.
We believe that the dilution of this regime has produced an overly short-termist corporate mindset which threatens to deter necessary long-term investments.
We therefore view the problems of weak investment, weak growth, the slow pace of green transitioning and corporate fragility as interlinked: the product of a short-termism that reflects the overly permissive guidance on distributable reserves and the creative accounting it incentivises.
Our argument is that companies too often use creative accounting and legal work to make cash distributions from non-cash (anticipated) revenues or by reporting speculative profits by ignoring/postponing important costs.
The incentive to do so lies in the lax enforcement of the 2006 Companies Act capital maintenance requirements that only ‘realised’ profits can be paid out legally.
This weakening of the capital maintenance regime creates an inter-temporal risk: if dividends are paid out today from profits linked to, for example, asset revaluations based on future expectations, then firms may not have the balance sheet buffers to absorb future shocks if those expectations turn out to be misplaced.
Economies are by their nature cyclical, and it is imprudent to allow firms to pay out today from speculative/unrealised income streams expected to accrue from future events that are always uncertain. The purpose of the Companies Act 2006 capital maintenance regime was to prevent this from happening.
The incentives to distribute today also disincentivises the recognition of likely future liabilities, such as asset retirement obligations for energy companies or water company liabilities, meaning necessary economic, social and environmental expenditures are not being made or provisioned for, storing up all kinds of contingent costs which will likely be borne by the State in the future.
We present evidence which shows the poor growth, investment and productivity performance of UK companies that over-distribute, who are, in many cases, paying out more in dividends than they generate in group net income for prolonged periods.
Tightening the enforcement of the capital maintenance rules of the 2006 Companies Act is therefore central to solving a number of inter-linked social, economic and environmental challenges in the UK.
In our view, the 2019 BEIS report ‘The Future of Audit’ provides the best start point for the policy discussion about capital maintenance and the reform of audit and corporate governance.
We conclude with reform recommendations from that report.
CORE (COnnecting REpositories)
CORE (COnnecting REpositories)