The Auditor's Red Flag and the Dividend
Petra is finance director of Loomis Fabrication Ltd, a private company with 40 employees. The company has retained profits of £800,000 on its balance sheet. The board wants to pay a dividend of £600,000 to the two shareholder-directors. Petra's draft accounts show a problem: a major customer, representing 35% of revenue, has gone into administration and £450,000 of receivables are unlikely to be recovered. The accounts have not yet been adjusted for this. If the write-off is made, retained profits fall to £350,000. The company also has a bank covenant requiring net assets above £500,000. The shareholder-directors say the dividend is needed personally and argue that the receivable may still be recovered in part. The auditor has not yet signed off the accounts. Petra is under pressure to approve the dividend before the year-end.
1. Can the company lawfully pay the £600,000 dividend? Analyse the distributable profits test and the effect of the receivable write-off.
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The distributable profits test. A company may only pay a dividend out of profits available for distribution. Those are accumulated realised profits not previously distributed, less accumulated realised losses not previously written off. The test is applied to the accounts used for the distribution.
Effect of the write-off. The £450,000 receivable is unlikely to be recovered. Prudence and accounting standards require it to be provided for if recovery is doubtful. Once adjusted, retained profits fall from £800,000 to £350,000. A £600,000 dividend would exceed distributable profits by £250,000. It would be unlawful.
Covenant. Even if the dividend were £350,000, net assets would fall below the £500,000 covenant threshold, triggering a default. The board must consider the covenant, though it is a contractual rather than a statutory constraint.
Partial recovery argument. The directors say part may be recovered. That does not rescue the dividend. The board must use a prudent estimate. If, say, £100,000 is expected, the write-off is £350,000 and retained profits are £450,000 - still below £600,000. The dividend remains unlawful.
Conclusion. The company cannot lawfully pay £600,000. The maximum lawful dividend is £350,000 on the adjusted figures, and even that breaches the covenant. The board should defer the dividend until the position is clear.
2. What are the consequences for Petra and the directors if the dividend is paid anyway, and what should Petra do?
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Consequences for the company and directors.
- Unlawful distribution: the company can recover the dividend from the recipients if they knew or had reasonable grounds to believe it was unlawful. As shareholder-directors, they clearly knew.
- Directors' liability: the directors may be personally liable to repay or compensate the company. They may also face disqualification for allowing an unlawful distribution.
- Criminal risk: knowingly paying an unlawful dividend can, in serious cases, amount to misconduct; the primary risk is civil liability and disqualification.
- Insolvency risk: if the company later fails, the payment may be challenged as a transaction at an undervalue or a preference.
Petra's position. As finance director, Petra has professional and legal duties. She should:
- Refuse to certify or approve the dividend on unadjusted figures.
- Put her concerns in writing to the board, with the adjusted calculation.
- Ask the auditor to confirm the treatment of the receivable.
- Propose a reduced dividend of no more than £350,000, and only if the covenant can be waived.
- If the board proceeds, record her dissent in the minutes and seek independent legal advice.
Exam point. Petra cannot rely on the directors' assurance that recovery may occur. She must apply a prudent estimate. Silence or acquiescence could expose her to personal liability. The correct answer is to document the objection and refuse to approve the unlawful payment.