Investors need to know what portion of a company’s profit has been realised in cash or near cash, and what portion has not. They also need to know what losses/liabilities are likely, even where they are hard to measure or uncertain in timing. Not only is this important to judging the reliability and quality of a business’s income stream, it is also key to determining a company’s true capital strength and ability to pay dividends: in the UK only accumulated realised profits – after accounting for foreseeable losses and liabilities – can legally be distributed to shareholders in the form of dividends or share buybacks.
Long-term investors want their companies to stick to a simple rule: cash must come in and not be required to cover foreseeable liabilities/losses, before cash is paid out as dividends.
The problem is that current accounting rules – International Financial Reporting Standards (IFRS) – are not designed to meet capital maintenance rules. Consequently, they do not distinguish between the realised and unrealised element of profits or capital, nor do they require all foreseeable losses/liabilities to be accounted for, leaving out those that are harder to measure or uncertain in timing.
As part of our campaign to ensure that accounting rules protect investors, we responded to the Brydon Review’s Call for Views into the quality and effectiveness of audit. This included our position paper ‘Investors must know what is real’, signed alongside 13 other investors including the Local Authority Pension Fund Forum, Legal & General Investment Management and Hermes. Together, these submissions set out our concern over the weaknesses in the UK’s capital maintenance regime and put forward a series of recommendations for action.