Reporting capital structure is challenging but markets are keen for the information, as Graham Holt explains
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
This article was first published in the October 2016 international edition of Accounting and Business magazine.
Often the advice given to investors is to focus on cash and cashflow when analysing corporate reports. Insufficient financial capital can cause liquidity problems and sufficient financial capital is essential for business growth. Any discussion of the management of financial capital is normally linked to entities that are subject to external capital requirements but the topic is just as important for those entities that do not have any such regulatory obligations.
What it is
Financial capital is defined in several ways. The term has no single accepted definition, having been variously interpreted as the equity held by shareholders or equity plus debt capital including finance leases. The definition chosen can obviously affect the way in which capital is measured, and that in turn has an impact on the return on capital employed (ROCE) figure.
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 of financial reports have diverse views about what is important in their analysis of capital. Some focus on the entity’s historical invested capital, some concern themselves with its accounting capital, and others look to its market capitalisation.
Investors have specific but different needs for information about the entity’s capital depending on the approach they take to the valuation of the business. For example, if their valuation approach is based on a dividend model, then a shortage of capital may have an impact on future dividends. If, however, ROCE is used for comparing the performance of entities, then investors need to know the nature and the 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 International Accounting Standards Board (IASB) considered whether it should require disclosures about capital. In any assessment of the risk profile of an entity, the management and level of the entity’s capital is an important consideration.
The IASB believes that disclosures about capital are useful for all entities, although it does not intend for those disclosures to replace the ones required by regulators as the latter’s 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 lay down similar requirements for equity instruments.
The IASB considered whether the definition of capital is different from the definition of equity in IAS 32, Financial Instruments: Presentation. In most cases disclosure of capital would be the same as for equity but it might include or exclude some 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.
IAS 1 disclosures
As a result, IAS 1 requires an entity to disclose information that enables users to evaluate its objectives, policies and processes for managing capital. This objective is gained 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 elements of capital while other entities regard capital as excluding some components of equity – for example, those arising from cashflow hedges. The IASB decided not to require quantitative disclosure of externally imposed capital requirements. It decided instead 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 the financial gearing is managed, how capital is managed to sustain product development, and how ratios are used to evaluate the appropriateness of the capital structure. An entity bases such disclosures on the information that is provided internally to key management personnel.
If the entity operates in several jurisdictions whose different external capital requirements would render an aggregate disclosure of capital of little value, then the entity may disclose separate information for each separate capital requirement.
Besides the requirements of IAS 1, the International Financial Reporting Standards (IFRS) practice statement on 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 make capital disclosures 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 that period.
Section 414 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 a consideration of how much capital it has and its sufficiency for the company’s needs.
The Financial Reporting Council’s 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.
The annual report is not the only document that an investor may consult to find details of an entity’s capital structure.
Where the entity is involved in a financial transaction, such as a sale of bonds or equities, it typically produces a capitalisation table in a prospectus that shows the effects of the proposed transactions on its capital structure. The capitalisation table lays out the ownership and debt interests in the entity, but may also show its potential funding sources, and the effect that any public offerings will have.
The 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 issuing of common stock, or the use of the proceeds raised by the offering 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 US, the capitalisation table is used to calculate key operational metrics. Amedica Corporation announced in February this year that it had ‘made significant advancements in its ongoing initiative toward improving its capitalisation table, capitalisation 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.
Debt and equity
Essentially there are two classes of capital reported in financial statements – namely, debt and equity. However, debt and equity instruments can have different levels of right, benefit and risk.
When an entity issues a financial instrument, it has to determine its classification either as debt or as equity. The classification that is assigned can have a significant effect on the entity’s reported results and financial position. Classifying an instrument as a liability affects an entity’s gearing ratios and results in any payments being treated as interest and charged to earnings; classifying it as equity may be seen as diluting existing equity interests.
IAS 32 sets out the nature of the classification process but the standard is principle-based and the resulting outcomes are sometimes surprising to users. IAS 32 does not look to the legal form of an instrument but focuses instead on the instrument’s contractual obligations.
IAS 32 considers the substance of the financial instrument, applying the definitions to the instrument’s contractual rights and obligations. The wide variety of instruments can make 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 financial instrument types have added further complexity to capital structures, leading to difficulties in interpretation and understanding.
The IASB has undertaken a research project with the aim of improving accounting for financial instruments that have characteristics of both liabilities and equity. The IASB has a major challenge in determining the best way to report the effects of recent innovations in capital structure.
Diversity and difficulty
There is a diversity of thinking about capital, which 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 highly business-specific and are influenced by many factors such as debt covenants and the preservation of debt ratings. The variety and inconsistency of capital disclosures can complicate the decision-making for investors. The details underlying a company’s capital structure are therefore essential in helping them assess any potential change in an entity’s financial flexibility and value.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan Business School
CPD technical article
"IAS 1 requires an entity to disclose information that enables users to evaluate its objectives, policies and processes for managing capital"