Capital maintenance – Where do we go from here? Capital maintenance – Where do we go from here? Capital maintenance – Where do we go from here?

Company distributions have become a controversial subject. Recent reviews by the Business, Energy and Industrial Strategy (BEIS) Select Committee, Sir John Kingman and Donald Brydon have all referred to this.

KPMG issued a paper in December 2019 to prompt further thought and discussion around this complex and important topic.

We revisited the topic this month, inviting representatives from several leading institutional investors and investor associations to discuss and debate the key issues alongside one FTSE 100 finance leader and an experienced audit committee chair and former FTSE 100 CFO; with representatives from the Financial Reporting Council (FRC) and BEIS in attendance.

The discussion yielded several key insights which we trust will assist in progressing resolution of these important matters.

Participants in the discussion all agreed that the most appropriate owner of any reformed regime would be the FRC’s successor – the Audit, Reporting and Governance Authority (ARGA) – provided that ARGA was armed with sufficient resources, skills and knowledge to deliver effective oversight.

Participants expressed a broader range of views on several of the other topics discussed in our paper, which fall broadly under three themes.

• Is there a need for a new realisation test?
• What would a different capital maintenance regime look like?
• What would constitute good disclosure of distributable profits?

On the whole, participants agreed that a new realisation test should be considered and a consultation would be welcome. (Under the current regime, the test is whatever is generally accepted practice for determining realised profits – see page 6 in our paper.)

Proponents noted that any changes should focus on the capital maintenance objective of protecting creditors; but also important is the directors’ fiduciary duty to shareholders to preserve company solvency. Many of those present agreed that the current regime needs tightening, highlighting that the existing rules are somewhat archaic and can be complicated to apply, are not outcome-focussed (and at times, do not reflect economic reality); and that they may result in unhelpful diversity in practice.

Some participants believe that the realisation test does not necessarily help matters, particularly as it does not directly address a company’s ability to pay debts post-distribution. Others noted that the test is somewhat useful but insufficient on its own to achieve the goals of the overall capital maintenance regime.

Participants identified several potential pitfalls for the new regime-owner to look out for when designing the new realisation test – particularly, the risk that a cash income test could result in companies’ ‘window-dressing’ the balance sheet by accelerating cash collections close to the year end.

It was also suggested that – to those who rely on accounting but are not accounting experts – the term ‘unrealised’ is a very technical distinction that is not readily understood; a change of language could help.

Participants expressed a wide range of views on whether a new regime should feature a prudential or a solvency test – both present advantages and challenges. (See Chapter 4 of our paper.) The focus of the discussion remained on these two options; there was wide, but not universal, interest in exploring alternative regimes.

How would each option work?

Prudential basis – Some participants are enthusiastic about this option, believing that this basis would address the quality of the assets available to meet creditors’ claims, and would possibly be easier to apply than a solvency basis.

However, caution was expressed from a corporate perspective that ‘one size would not fit all’ and that creditors with a higher-than-typical risk tolerance (e.g. investors in high yield debt) – particularly those who are creditors of non-financial companies – would need to be accommodated; although others felt that those who invest in this type of debt should be aware of the risks and have no obvious need of additional protection.

Some participants warned that – as can be the case with prudential regulation – there is a risk of addressing the last crisis, without paying sufficient attention to the next risk (e.g. climate change).

Solvency basis –  It was acknowledged that the fiduciary duty requires consideration of solvency, and that a formal solvency basis would build on that. Some participants noted the risks inherent to considering a tightly-defined time period in the cash flow test, e.g. a 24-month test, could ignore the risk of bankruptcy in month 25 and future risks. Some noted the risk of a strictly quantitative focus on the part of management under such a regime, without reflecting the broader objective of maintaining company solvency in the medium-to-long term. Parallels were drawn with the approach to corporate resilience needing to balance short, medium and long term expectations and risks.

Some participants noted that these alternative regimes are worthy of further consultation and debate. Such regimes could be applied in combination with a revised realisation test to determine the pool of available earnings for distribution or by simply using GAAP profits as the starting point for a prudential- or solvency-based distribution test.

As with many of the topics that we engage with investors about, there was a general consensus among participants that transparency is key to giving investors what they need.

Investors want to see clear disclosure of the balance of distributable profits not only for the parent company but also pro forma reserves that the parent company could realistically raise from subsidiaries. It was also noted that – if this were implemented – there would be a need for additional disclosure on the risks and potential ‘dividend blocks’ in the group structure (e.g. foreign exchange exposures, capital controls or prudential regulation that could affect cash flowing out of a subsidiary).

Some participants flagged the great complexity that preparers of financial reports would need to navigate in applying a group basis, and that consultation would be needed to settle whether this was desirable and, if so, how it could be implemented – particularly without introducing boilerplate disclosures.

BEIS is expected to publish its consultation on audit market reform, including a response to the recommendations suggested in the Brydon Review and the BEIS Select Committee Report on the Future of Audit, in late 2020. This will include reform of the capital maintenance providing investors the opportunity to direct reform of this important but contentious topic.

In the meantime, we would welcome any further comments from investors and other key stakeholders on which disclosures they feel would be valuable in this area.

Our Capital Maintenance roundtable session with investors and analysts was held on 18 September 2020. It is one of a series of investor outreach events we hold to discuss and share perspectives on how corporate reporting, auditing and assurance, and stewardship can evolve to meet investors’ needs today and in the future. To find out more, visit our web page or follow KPMG Investor Insights on LinkedIn. If you would like to discuss any of the areas in more detail on a one-to one basis, contact us at investorinsights@kpmg.co.uk.

With thanks to Mike Metcalf for his contribution to the discussion and this article.