24 July 2017 by Natasha Landell-Mills
Natasha Landell-Mills of Sarasin & Partners says directors can help investors understand a company’s true financial strength.
In May, a group of investors – including myself – and the UK Shareholders Association released a paper calling for firms to disclose more detail on the extent their earnings are based on realised or unrealised gains.
We also sought a better understanding of the extent to which companies’ reported capital includes undistributable reserves. As investors, we believe this information is vital for judging the reliability of a business’s income stream, and also determining a company’s true capital strength and ability to pay dividends.
I believe that, on this issue of better clarity over profit and capital, directors and shareholders ought to be fully aligned. More transparency would strengthen investors’ understanding of the business, improve the quality of discussion and build trust. At the same time, there is little evident downside.
Even so, to make the case for director support, it is important to make a clear case for a change in the status quo.
It should be no surprise that visibility over profits and capital is important to shareholders.
Knowing whether profits have been realised in cash or near cash, rather than through mark-to-market gains on a trading book or anticipated profits from long-term contracts, is helpful to knowing how secure that profit is.
Because the reported profits then flow into the capital number on the balance sheet, it is important to know what part of the reported capital is realised or not. This is an indicator of capital strength, as unrealised retained earnings may never be realised, and are therefore lower quality.
“Trust underpins the ability of listed companies to raise capital”
Better visibility would also provide investors with a guide to dividend-paying capacity, because company law requires that unrealised profit cannot be distributed. In addition, investors will naturally want to know whether there are any provisions for likely losses or liabilities that mean capital cannot be distributed.
On a broader level, investors believe that the current system-wide failure to disclose this information risks undermining trust in capital markets.
This matters, because trust underpins the ability of listed companies to raise capital. When investors lose faith in companies’ financial accounts they become less likely to provide fresh capital.
Opacity in markets is equivalent to throwing sand into a well-oiled machine: it stops working smoothly and overall efficiency falls. In the extreme the whole machine can break down, which is effectively what happened in the most recent financial crisis.
As the above shows, having greater visibility over components of profits and capital is important.
The problem is that current accounting rules – International Financial Reporting Standards (IFRS) – do not distinguish between the realised and unrealised elements of profits, nor do they break out the capital that is not distributable.
Investors are therefore now asking firms whether they will provide this disclosure alongside their IFRS accounts.
For several investors, the disclosure of realised profits and non-distributable capital is already mandated under the capital maintenance regime in company law. As justification, they point to recent legal opinions provided by George Bompas QC in 2013 and 2015, as well as case law.
Despite this, the position has not yet been accepted by the Financial Reporting Council, and there does not appear to be any clear resolution on the horizon.
The investors that published their position paper in May have therefore suggested that the legal question be put to one side to permit talk between investors and their companies.
Although questions exist over whether companies are required to publicly disclose their realised profits and non-distributable reserves, everyone agrees that this information must be available to directors so they are able to fulfil their legal duty under the Companies Act 2006 not to distribute out of capital.
Since IFRS accounts do not provide the requisite information, directors need to rely on other numbers to determine company distributions.
Given that directors already have visibility from these ‘other numbers’ over non-distributable reserves, it should be shared with investors who – as outlined above – have strong reasons for wishing to see it. There are several good reasons for directors and shareholders to work together to improve understanding on this matter.
Primarily, better disclosure would improve trust by enabling directors to demonstrate to investors exactly what funds are available for distribution, why other capital is not, and how these amounts are changing over time.
Although affecting only a handful of companies, the recent examples of FTSE-listed companies reporting that they paid illegal dividends has raised market awareness of the risk directors may not always be monitoring their distributable reserves sufficiently closely, potentially putting shareholder capital at risk.
“Misunderstanding and friction between investors and directors can frequently come down to differing levels of knowledge”
Second, by providing more detail on the nature of the profits being made, their durability, and likely future liabilities, discussion between shareholders and directors would be better informed and more productive.
Misunderstanding and friction between investors and directors can frequently come down to differing levels of knowledge. By shrinking the gap in information, the chances of more fruitful conversations rise.
Finally, a better understanding of profitability would help in conversations over pay. Shareholders would likely welcome a closer link between remuneration and creating enduring value, which takes out the influence of potentially ephemeral market gains or the booking of anticipated profits.
Although it is true that the lack of clarity on realised and unrealised profits is especially damaging in the case of banks, disclosing the amount of undistributable reserves and the breakdown in profits is important for all businesses.
For companies that recognise revenue from long-term contracts before payments are actually received, it is important for shareholders to know exactly when the cash has been realised and when it has not. Currently this is not visible either in the profit and loss account or the cash flow statement.
The danger is that early revenue recognition may provide a misleading impression of profits, and then capital strength. This has been a problem in the support service sector, for instance. Revisions to IFRS15, the standard that deals with revenue recognition, will not provide disclosure on income realisation.
Although dividends are legally paid from the distributable reserves in the holding or parent company, the parents’ numbers show little about the dividend-paying capacity of the group. Also, there is considerable flexibility for companies to manipulate the parent numbers through intra-group transfers.
Importantly, where there are problems brewing within a subsidiary that could materially affect dividends in the future, this will not necessarily be visible in the parent’s accounts.
Although it is clearly a bigger undertaking to provide group-wide visibility, the information on any practical or policy restrictions on what could be legally distributed is useful information for shareholders.
The debate over the legality of IFRS has become bogged down, but this should not prevent progress. The faster investors and directors can come together to sort out this important matter, the less relevant the legal debate becomes – and on substance there is far more here to unite shareholders and directors than divide them.