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By Nick Anderson, Member, International Accounting Standards Board

It can sometimes appear that equity markets are overly focused on net profit—or earnings per share—but in practice, no number in isolation can adequately capture corporate performance. Investors seek to understand the quality of the profit number, not just the amount of earnings.

How much capital has the business deployed to generate this level of profit? How persistent are earnings likely to be into the future? Does net profit include gains or expenses that are unlikely to reoccur? Is the pattern of future profits likely to exhibit volatility or cyclicality? To what extent are profits supported by cash flow generation? What are the long-term risks faced by the business, including material environmental and social factors? Investors are likely to consider all these questions in their assessment of the sustainability of future profits, drawing on the audited financial statements, management commentary and multiple other information sources.

Most long-term investors will analyse the return on investment a business has generated over a number of years and consider whether this can be sustained into the future. Likely developments in the competitive environment and related opportunities for reinvestment are a particular focus. What are the opportunities for further capital deployment and what is the likely return on this capital? Does the business generate sufficient cash flow to take advantage of these opportunities? Is the financial structure appropriate given the inherent risk profile of the business?

The importance of cash flows

Academic research on accruals and the quality of profits highlights the importance of cash-flow generation. Many investors also seek to understand changes in a company's financial liabilities that are not cash flows themselves but are economically equivalent to cash flow movements. In 2016 the International Accounting Standards Board (IASB) published an amendment to IAS 7 Statement of Cash Flows, designed to help users reconcile changes in liabilities arising from financing activities.

In addition to the issues outlined above, the extent of reinvestment opportunities and cash flow generation will be important considerations in determining the most appropriate dividend policy for a company. When a business faces financial stress it can be important, sometimes essential, to reduce the dividend strain on cash flow. Equally, for companies that generate good returns and have plentiful opportunities for reinvestment, a low or even no dividend would best serve shareholders. In contrast, a mature business generating steady returns with few opportunities for growth might be expected to pay out a high proportion of profits in dividends.

National dividend regulations

Consideration of these issues alone, however, is not sufficient to determine an appropriate dividend payment. In many jurisdictions, compliance with national legislation or regulation also plays a key part in determining the level of dividend payment. Capital maintenance regimes for example are a common component of national company law systems. They are essentially an instrument of public policy and reflect jurisdictional preferences for how restrictive or permissive dividend distribution regimes should be. Ensuring adherence to capital maintenance regimes is a matter for company directors, together with their auditors and regulators. In many jurisdictions directors, in determining an appropriate dividend payment, must undertake additional checks to ensure compliance with capital maintenance regimes. Where appropriate, companies may supplement IFRS financial statements with further disclosures, about dividend policy.

IFRS Standards support long-term investment through transparent financial reporting, contributing to the operation of healthy and efficient capital markets as well as meeting investor demand for increased comparability across international markets. This helps capital market participants make better informed and more efficient decisions. Our Standards also provide investors with information to assist their assessment of how effectively a company’s management have used the resources entrusted to them.

Accounting—one piece of the jigsaw

However, it is important to remember that IFRS Standards, if only because of their international nature, cannot reflect in detail specific requirements of the multitude of different capital maintenance regimes among the more than 140 jurisdictions that now require the use of our Standards. As such, although accounting profit is an important piece of information it should not be used in isolation as the sole determinant of the level of dividend distribution.

Accounting is just ’one piece of the jigsaw’. As highlighted above, dividend policy reflects many other factors such as reinvestment opportunities, financing needs, the risks faced by the company, legal constraints and incentive arrangements. These factors differ by company, by jurisdiction and over time. The complexity of determining what an appropriate level of dividend payment should be also explains why jurisdictional capital maintenance regimes are often complex and require the use of judgement.

Directors are required to comply with their legal obligations. The responsibility to determine whether dividend payments are appropriate is beyond the remit of the IASB. However, there is no impediment to complementing high quality financial statements prepared in accordance with IFRS Standards by providing additional disclosures about dividend policies and dividend payments, including any disclosures needed to meet jurisdiction requirements.