Sometime back in 2019, we wrote an article entitled “Perpetual securities are debts, not equity. Here’s why.” (The article was published in the April 1 issue of The Edge. To read it, please scan the QR code.)
In that fairly theoretical and lengthy piece, we articulated the fact that practising accountants were intentional in misclassifying perpetual securities (or perps) as equity — to strengthen the balance sheets and income statements of the clients that they work for and audit. While they relied on certain accounting standards (like IAS 32) for justification, we argued that practising auditors were drawing upon a limited and specific section while ignoring the context and, indeed, refusing to read the entirety of the statement or facts.
What is worth repeating here is the simplified and exaggerated example we used of how a hypothetical company can greatly distort its financial health by issuing perps (see Table 1).
With perps recognised as equity, the gearing of this company is 5%, giving the impression that it has almost no debts and is therefore totally safe. In reality, it is a hugely leveraged and risky company with 567% gearing. It is also presented as a profitable company, with $28 million in profit after tax. In truth, it made an after-tax loss of $20 million.
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Why are we revisiting this topic? As interest rates rise, liquidity diminishes, demand slacks and economic growth slows, the cash flows of companies will become more challenging. Against such a backdrop, misrepresentation of financial health, especially on cash flows and leverage, can have severe consequences for unknowing investors.
Let’s backtrack a little and start with the basic question of why companies must prepare financial statements and for whom. For the company, financial statements provide a snapshot of its financial situation, giving insights into its performance, operations and cash flow — with information derived from revenue, expenses, profitability, debts and so on. These financial statements are then used by investors, market analysts and creditors to evaluate the company’s financial health and earnings potential.
In this article, we will focus only on the facts, namely, who uses perps and why, who invests in them and what implications, if any, there are for stock market investors in listed companies that issue perps — and the potential implications for auditors and company directors.
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Who uses perps?
Table 2 is a list of perps issued, by country and categorised into bank and non-bank issuers. Clearly, companies in many countries have issued perps, but none more so than in Asia and, in particular, China.
Perps have a long history dating back centuries. The British government issued its first perps (known then as consols) way back in 1751 — one of the earliest perps in recorded history — and has used them to finance wars, including World War I. Tellingly, these perps are classified as perpetual bonds (with fixed coupon payments and no maturity date) and form part of the government’s debts. In 2015, the UK government decided to redeem all of its outstanding perps.
More recently, perps have become popular among banks as a means to raise additional capital buffer needed to meet the requirements under Basel III (implemented in the aftermath of the global financial crisis), without having to resort to issuing dilutive equity.
Under the new Basel requirements, to increase financial resilience, banks must boost their Tier 1 capital to a minimum of 6% of risk-weighted assets, of which at least 4.5% must consist of common equity. Perps — and other subordinated debts — qualify as Additional Tier 1 capital to make up the balance 1.5%. For instance, some US banks use preference shares as part of their Additional Tier 1 capital. Note that perps issued by banks are fairly safe instruments given that the sector is highly regulated and there is high certainty of future cash flows (huge loans base with fixed scheduled repayments).
In the US, perps are also common among utilities, telcos and infrastructure companies, which are relatively low-risk businesses with long-term projects to finance. Across Asia, perps have caught on in recent years, becoming a popular source for raising funds, especially for companies that expanded quickly, for instance in the real estate and oil and gas sectors.
For more stories about where money flows, click here for Capital Section
Who invests in perps?
The biggest investors in perps are bond investors, primarily pension fund managers and insurance companies. Of note, when there is a credit rating attached to the perps issue, it is almost never considered as pure 100% equity — no matter what it is called or treated as from an accounting point of view on the issuer’s balance sheet.
Fact: Professionals like rating agencies (that use accounting statements) rate perps as part debt-part equity. In Malaysia and Singapore, perps are typically rated as 50% debt, though it can range from as low as 30% to as high as 65% (see Table 3). Clearly, rating agencies do not consider perps “equity”. Even more telling is the fact that tax authorities allow for perps distributions to be treated as tax-deductible expenses — just like its treatment of interest expense on debts and unlike dividends for stocks, which are not tax-deductible. Add to that the fact that perps are basically owned by bondholders and it shows that they are not equity.
Bondholders understand what they are investing in — perps, like debts, are essentially fixed-income assets that match their long-dated liabilities. They know and accept the risks for these hybrid instruments, and are compensated in the yields, which tend to be slightly higher than other forms of pure debts.
The question is, do investors who buy the stocks of companies issuing perps understand their risks? This is especially pertinent given that highly leveraged companies are increasingly using perps to raise funds. Their accounting treatments — by accountants and auditors alike — are more likely to misrepresent the financial health of these companies. Some of the high-profile, big perps issuers that have run into financial troubles include Singapore-listed Hyflux Ltd and property developer The China Evergrande Group.
Equally important, if unsophisticated equity investors bought shares by relying on financial statements — where liabilities are miscategorised as equity, a fact that is acknowledged as such by professional rating agencies — could there be recourse against those responsible for these financial statements? In other words, should the accountants, auditors and directors of these companies be held liable?
In summary, we have demonstrated in this article the fact that perps are liabilities. This is true, both in reality and conceptually. In practice, real-world evidence clearly shows how they are viewed by issuers, professionals and tax authorities — even if some of these same issuers and professionals insist on representing them as equity to the general public. For theory — and this is a reminder to all qualified accountants and auditors of their role and the responsibilities of their profession — we highlight several relevant paragraphs from the “Conceptual Framework for Financial Reporting” below.
The framework was issued by the International Accounting Standards Board (IASB) in September 2010 and revised in March 2018. Its main objective is to provide definitive and consistent concepts for (1) the IASB to develop and revise accounting standards, IFRS and (2) those preparing financial statements to develop consistent accounting policies in areas not covered by any specific standard and, critically, to understand and interpret the standards, when a choice is available.
The Global Portfolio closed marginally lower for the week ended April 20, down 0.4%. Yihai International Holding was the top gainer, its shares surging by 17.6%. The two other gainers in the portfolio were Bank of America Corp (+2.2%) and Guangzhou Automobile Group Co (+1.9%). Alibaba Group Holding (-8%), CrowdStrike Holdings (-7.2%) and Airbnb (-4.2%) were the big losers last week. Total portfolio returns now stand at 44.6% since inception. This portfolio is underperforming the benchmark MSCI World Net Return Index, which is up 53.2% over the same period.
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