Why does it matter anyway?

This article is useful to those candidates studying for P2, Corporate Reporting. It is structured in two parts: first, it considers what might be included as the capital of a company and, second, why this distinction is important for the analysis of financial information.

Essentially, there are two classes of capital reported in financial statements: debt and equity. However, debt and equity instruments can have different levels of right, benefit and risks. When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The result of the classification can have a significant effect on the entity’s reported results and financial position. Liability classification impacts upon an entity’s gearing ratios and results in any payments being treated as interest and charged to earnings. Equity classification may be seen as diluting existing equity interests.

IAS 32, Financial Instruments: Presentation sets out the nature of the classification process but the standard is principle-based and sometimes the outcomes that result from its application are surprising to users. IAS 32 does not look to the legal form of an instrument but focuses on the contractual obligations of the instrument. IAS 32 considers the substance of the financial instrument, applying the definitions to the instrument’s contractual rights and obligations.

MORE COMPLEXITY

The variety of instruments issued by entities makes this classification difficult with the application of the principles occasionally resulting in instruments that seem like equity being accounted for as liabilities. Recent developments in the types of financial instruments issued have added more complexity to capital structures with the resultant difficulties in interpretation and understanding. Consequently, the classification of capital is subjective which has implications for the analysis of financial statements.

To avoid this subjectivity, investors are often advised to focus upon cash and cash flow when analysing corporate reports. However, insufficient financial capital can cause liquidity problems and sufficiency of financial capital is essential for growth. Discussion of the management of financial capital is normally linked with entities that are subject to external capital requirements, but it is equally important to those entities that do not have regulatory obligations.

Financial capital is defined in various ways but has no widely accepted definition having been interpreted as equity held by shareholders or equity plus debt capital including finance leases. This can obviously affect the way in which capital is measured, which has an impact on return on capital employed (ROCE). An understanding of what an entity views as capital and its strategy for capital management is important to all companies and not just banks and insurance companies. Users have diverse views of what is important in their analysis of capital. Some focus on historical invested capital, others on accounting capital and others on market capitalisation.

Investors have specific but different needs for information about capital depending upon their approach to the valuation of a business. If the valuation approach is based upon a dividend model, then shortage of capital may have an impact upon future dividends. If ROCE is used for comparing the performance of entities, then investors need to know the nature and quantity of the historical capital employed in the business. There is diversity in practice as to what different companies see as capital and how it is managed.

There are various requirements for entities to disclose information about ‘capital’. In drafting IFRS 7, Financial Instruments: Disclosures, the IASB considered whether it should require disclosures about capital. In assessing the risk profile of an entity, the management and level of an entity’s capital is an important consideration. The IASB believes that disclosures about capital are useful for all entities, but they are not intended to replace disclosures required by regulators as their reasons for disclosure may differ from those of the IASB. As an entity’s capital does not relate solely to financial instruments, the IASB has included these disclosures in IAS 1, Presentation of Financial Statements rather than IFRS 7. IFRS 7 requires some specific disclosures about financial liabilities; it does not have similar requirements for equity instruments.

The IASB considered whether the definition of capital is different from the definition of equity in IAS 32. In most cases, capital would be the same as equity but it might also include or exclude some other elements. The disclosure of capital is intended to give entities the ability to describe their view of the elements of capital if this is different from equity.

As a result, IAS 1 requires an entity to disclose information that enables users to evaluate the entity’s objectives, policies and processes for managing capital. This objective is obtained by disclosing qualitative and quantitative data. The former should include narrative information such as what the company manages as capital, whether there are any external capital requirements and how those requirements are incorporated into the management of capital. Some entities regard some financial liabilities as part of capital, while other entities regard capital as excluding some components of equity – for example, those arising from cash flow hedges.

The IASB decided not to require quantitative disclosure of externally imposed capital requirements but rather decided that there should be disclosure of whether the entity has complied with any external capital requirements and, if not, the consequences of non-compliance. Further, there is no requirement to disclose the capital targets set by management and whether the entity has complied with those targets, or the consequences of any non-compliance.

Examples of some of the disclosures made by entities include information as to how gearing is managed, how capital is managed to sustain future product development and how ratios are used to evaluate the appropriateness of its capital structure. An entity bases these disclosures on the information provided internally to key management personnel. If the entity operates in several jurisdictions with different external capital requirements, such that an aggregate disclosure of capital would not provide useful information, the entity may disclose separate information for each separate capital requirement.

TRENDS

Besides the requirements of IAS 1, the IFRS Practice Statement Management Commentary suggests that management should include forward-looking information in the commentary when it is aware of trends, uncertainties or other factors that could affect the entity’s capital resources. Additionally, some jurisdictions refer to capital disclosures as part of their legal requirements.

In the UK, Section 414 of the Companies Act 2006 deals with the contents of the Strategic Report and requires a ‘balanced and comprehensive analysis’ of the development and performance of the business during the period and the position of the company at the end of the period. The section further requires that to the extent necessary for an understanding of the development, performance or position of the business, the strategic report should include an analysis using key performance indicators. It makes sense that any analysis of a company’s financial position should include consideration of how much capital it has and its sufficiency for the company’s needs. The Financial Reporting Council Guidance on the Strategic Report suggests that comments should appear in the report on the entity’s financing arrangements such as changes in net debt or the financing of long-term liabilities.

In addition to the annual report, an investor may find details of the entity’s capital structure where the entity is involved in a transaction, such as a sale of bonds or equities. It is normal for an entity to produce a capitalisation table in a prospectus showing the effects of the transactions on the capital structure. The table shows the ownership and debt interests in the entity but may show potential funding sources and the effect of any public offerings. The capitalisation table may present the pro forma impact of events that will occur as a result of an offering such as the automatic conversion of preferred stock, the issuance of common stock, or the use of the offering proceeds for the repayment of debt or other purposes.

The IASB does not require such a table to be disclosed but it is often required by securities regulators. For example, in the USA, the table is used to calculate key operational metrics. Amedica Corporation announced in February 2016 that it had ‘made significant advancements in its ongoing initiative toward improving its capitalization table, capitalization, and operational structure’.

It can be seen that information regarding an entity’s capital structure is spread across several documents including the management commentary, the notes to financial statements, interim accounts and any document required by securities regulators.

The IASB has undertaken a research project with the aim of improving the accounting for financial instruments that have characteristics of both liabilities and equity. This is likely to be a major challenge in determining the best way to report the effects of recent innovations in capital structure.

There is a diversity of thinking about capital that is not surprising given the issues with defining equity, the difficulty in locating sources of information about capital and the diversity of business models in an economy. Capital needs are very specific to the business and are influenced by many factors, such as debt covenants and preservation of debt ratings. The variety and inconsistency of capital disclosures does not help the decision making process of investors.

Therefore, the details underlying a company’s capital structure are essential to the assessment of any potential change in an entity’s financial flexibility and value. An appreciation of these issues and their significance is important to candidates studying for P2.

Written by a member of the P2 examining team

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