(a)    (i) Importance of information concerning an entity’s capital
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 risks. Hence, the details underlying a company’s capital structure are absolutely essential to assessing the prospects for changes in a company’s financial flexibility, and ultimately, its value.
For investors who are assessing the risk profile of an entity, the management and level of an entity’s capital is an important consideration. Disclosures about capital are normally in addition to disclosures required by regulators as their reasons for disclosure may differ from those of the International Accounting Standards Board (IASB). The details underlying a company’s capital structure are essential to the assessment of any potential change in an entity’s financial standing.
Investors have specific but different needs for information about capital depending upon their approach to their investment in an entity. If their approach is income based, 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. Some investors will focus on historical invested capital, others on accounting capital and others on market capitalisation.
Published information
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 Financial Instruments: Disclosures. Although IFRS 7 requires some specific disclosures about financial liabilities, it does not have similar requirements for equity instruments.
As a result, IAS 1 requires an entity to disclose information which 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. The IASB 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.
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 which could affect the entity’s capital resources. Additionally, some jurisdictions refer to capital disclosures as part of their legal requirements.
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 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 financial statements and any document required by securities regulators.
Integrated reporting
The capitals identified by the International Integrated Reporting Council (IIRC) are: financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital, and natural capital. Together, they represent stores of value which are the basis of an organisation’s value creation. Financial capital is broadly understood as the pool of funds available to an organisation. This includes both debt and equity finance. This description of financial capital focuses on the source of funds, rather than its application which results in the acquisition of manufactured or other forms of capital. Financial capital is a medium of exchange which releases its value through conversion into other forms of capital. It is the pool of funds which is available to the organisation for use in the production of goods or the provision of services obtained through financing, such as debt, equity or grants, or generated through operations or investments.
(ii) Whether an instrument is classified as either a financial liability or as equity is important as it has a direct effect on an entity’s reported results and financial position. The critical feature of a liability is that, under the terms of the instrument, the issuer is or can be required to deliver either cash or another financial asset to the holder and it cannot avoid this obligation. An instrument is classified as equity when it represents a residual interest in the issuer’s assets after deducting all its liabilities. If the financial instrument provides the entity an unconditional discretion, the financial instrument is equity.
IAS 32 Financial Instruments Presentation sets out the nature of the classification process but the standard is principle based and sometimes the outcomes are surprising to users. IAS 32 focuses on the contractual obligations of the instrument and considers the substance of the contractual rights and obligations. The variety of instruments issued by entities makes this classification difficult with the application of the principles occasionally resulting in instruments which 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.
Equity and liabilities are classified separately in the statement of financial position. The Conceptual Framework distinguishes the two elements by the obligation of the entity to deliver cash or other economic resources from items which create no such obligation. The statement of profit or loss and other comprehensive income (OCI) includes income and expenses arising from liabilities which is interest and, if applicable, remeasurement and gain or loss on settlement. The statement does not report as income or expense any changes in the carrying amount of the entity’s own equity instruments but does include expenses arising from the consumption of services which fall under IFRS 2 Share-based Payment. IFRS 2 requires a valuation of the services consumed in exchange for the financial liabilities or equity instruments.
In the statement of financial position, the carrying amount of many financial liabilities changes either with the passage of time or if the liability is remeasured at fair value. However, the amount reported for classes of equity instruments generally does not change after initial recognition except for non-controlling interest.
Liability classification typically results in any payments on the instrument being treated as interest and charged to earnings. This may in turn affect the entity’s ability to pay dividends on its equity shares depending upon local legislation.
Equity classification avoids the negative impact which liability classification has on reported earnings, gearing ratios and debt covenants. It also results in the instrument falling outside the scope of IFRS 9 Financial Instruments, thereby avoiding the complicated ongoing measurement requirements of that standard.
(b)    In the case of the first class of preference shares, even though there are negative consequences of not paying dividends on the preferred shares as agreed contractually, the company can avoid the obligation to deliver cash. The preferred shares do have redemption provisions but these are not mandatory and are at the sole discretion of the management committee and therefore the shares should be classified as equity.
In the case of the second class, the contractual term requires no dividend to be paid to ordinary shareholders if a payment is not made on the preferred shares. In this case, as Amster can avoid the obligation to settle the annual dividend, the shares are classified as equity. Thus $75 million should be transferred from liabilities to equity.
IFRS 2 Share-based Payment states that cash settled share-based payment transactions occur where goods or services are paid for at amounts which are based on the price of the company’s equity instruments. The expense for cash settled transactions is the cash paid by the company and any amounts accrued should be shown as liabilities and not equity. Therefore Amster should remove the following amount from equity and show it as a liability.
Expense for year to 30 November 2017 is:
((1,500 – 180 employees x 250 awards x $35) x 1/3 = $3·85 million
As a result of the adjustments to the financial statements, Amster’s gearing ratio will be lowered significantly as the liabilities will drop from 53·8% of total capitalisation to 33·2% of total capitalisation. However, the ROCE may stay the same even though there is an increase in shareholders equity as total capitalisation has not changed. However, this will depend upon the definition used by the entity for capital employed.
Amster Group – capitalisation table