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IFRS: a model answer
Martin Jones sets a question on equity and debt – and provides a specimen answer
There’s a word loaded with meaning and ambiguity. And this ambiguity can have a massive influence on how users view an entity. The phrase ‘capital’ is usually taken to mean ‘financial capital’, as in debt plus equity, and is the bottom of the key ratio return on capital employed, or ‘ROCE’, as everyone calls it. The problem is that this ratio is very widely used but because the meaning of capital is ambiguous the widespread use of ROCE introduces problems of inconsistency and incomparability.
The problem is further compounded by the lack of clarity in the distinction between the above two. This ‘debt/equity problem’ has been kicking around forever and I have written about it before. It can be very difficult for an entity to distinguish its debt from its equity. Indeed, some issued capital can have features of both. The classic example is preference shares. These financial instruments were going out of fashion when I started accounting in 1990. But preference share issue seems to be raising its head again. National Grid recently issued prefs and won a prize for innovation. You know the guys. Always digging up your roads and then disappearing off for a cup of tea. A little harsh, but I bet you wish they were as innovative with their roadworks as they are with their capital issues.
Anyhow, I thought you might like to see a question and answer on this subject, so here we go…
The definitions of ‘debt’ and ‘equity’ are problematical in financial reporting. Discuss this problem and the resultant effects on ratio analysis by users.
Here is an answer using the standard heading + sentence + sentence structure.
The key ratio affected by the ambiguity of debt and equity is return on capital employed. ROCE is usually defined as profit before interest and tax (PBIT) divided by debt plus equity.
Users widely use this ratio to analyse investment decisions. Essentially, the higher the ROCE, the more keen investors will be to put in their money, either by buying shares or lending loans.
One problem is that the phrase ‘debt’ is entirely undefined within financial reporting. Some companies include lease liabilities and overdraft and short-term borrowing and others do not.
This problem is particularly visible in published ROCE. This should be comparable from Tesco to Sainsbury to Carrefour to Walmart. But ROCE is not comparable because of the different interpretations of debt.
This problem is exacerbated by the compulsory publication of performance analysis required by law in many countries (UK and the US, for example) and by culture in other countries (France and South Africa, for example).
This compulsory publication of ROCE is usually in the Management Commentary component of the annual report. ROCE is then copied across to the Integrated Reports of entities that embrace integrated reporting.
And that is just the start of the problems. Another massive problem is the poor quality definition of equity. This is defined within the conceptual framework as the residual in this classic equation: equity = assets – liabilities.
That looks fine until you look a little harder. The equation says equity is what is left over when all the assets are turned into cash and the suppliers have been paid off. But this describes liquidation and has limited meaning in a going concern.
The solution to the problem of defining equity is part solved in a standard dedicated to this issue (IAS 32). This IFRS defines equity as ‘not a liability’ or in more detail ‘possessing no contractual obligations to cash outflows’. But this definition is often criticised as it says what equity is not rather than what it is.
Problem with the solution
Because the above solution (IAS 32) is so clumsy, the definition works poorly in practice resulting in interpretation errors where debt is classed as equity and equity is classed as debt.
This makes no difference to ROCE but makes a huge difference to another widely used ratio; gearing. Gearing is usually defined as debt over debt plus equity. Clearly a misclassification of debt as equity would reduce the quoted gearing.
In theory it should not matter if entities mess up their classification. This is because in theory everything you need to know about the financial structure of the entity should be disclosed. But in practice disclosure of finance is often poor.
• Martin Jones is a lecturer at LSBF
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