[Initial Perspective] Genuine Capital and Low-Quality Capital

Increase in Perpetual Bonds within Corporate Equity
Greater Risk of Misunderstanding Financial Information Such as Debt Ratio
Clarify Disclosures to Resolve 'Window Dressing' Controversy

Not all equity capital is the same. There is high-quality, pure capital, and there is low-quality capital that is ambiguous to recognize as capital. Capital stock and Additional Paid-In Capital (APIC) that flow into a company during the stock issuance process are high-quality capital. Retained earnings accumulated within the company from successful business operations are also included in high-quality capital. Genuine capital can sufficiently buffer losses within the scale of equity capital even if the company's performance deteriorates somewhat.

On the other hand, low-quality capital is capital but does not function adequately as a loss buffer. These are hybrid securities with characteristics between capital and debt, ambiguous to classify strictly as either debt or capital. Perpetual bonds, issued by both financial companies and general corporations, and contingent convertible bonds (CoCo bonds), mainly issued by financial holding companies and banks, are representative examples.

Perpetual bonds, by contract terms, are capital that does not have to be repaid forever. They have maturities of over 30 years, and if investors accept continuously rising interest payments, the principal and interest do not need to be repaid. They are like capital that the company can continuously use while regularly paying dividends to investors. However, in reality, if the principal and interest are not repaid by a certain date (the early redemption option exercise deadline), the borrowing rate surges, and it becomes difficult to raise new funds in the capital market, resulting in treatment akin to a near-default company. Heungkuk Life Insurance's history of postponing the exercise of the early redemption option (call option) on perpetual bonds and nearly being expelled from the capital market is a case in point.

The International Accounting Standards Board (IASB), which establishes and revises International Financial Reporting Standards (IFRS), allows companies to record perpetual bonds as equity when raising funds. In Korea, starting with Doosan Infracore (now HD Hyundai Infracore) in 2012, general companies have consecutively issued perpetual bonds to reduce their debt ratios.

The problem is that recently, as the issuance of perpetual bonds by general companies has rapidly increased, some companies have an excessively large proportion of perpetual bonds within their equity capital. In some large conglomerate affiliates, almost all of their equity capital is filled with perpetual bonds. Despite incurring large net losses over several years, they have filled the gap in reduced capital solely with perpetual bonds without issuing new shares. If perpetual bonds are excluded from equity, it is effectively a state of complete capital erosion.

This causes misunderstandings among stock and bond investors regarding corporate financial information. It becomes difficult to distinguish companies that fill their capital with high-quality capital from those that fill it with low-quality capital based solely on the debt ratio. There are even corporate presentations (IR) marketing that claim to have reduced the debt ratio to the 300% range by issuing perpetual bonds, even though the actual debt ratio exceeds 1000% without perpetual bonds.

However, it is not possible to record perpetual bonds, which the IASB internationally recognizes as equity, as debt on financial statements. Nevertheless, there seems to be a need to specify disclosures about the nature of capital to distinguish the quality of capital. If sufficient information disclosure is made and the quality of capital is clearly distinguished, the accounting manipulation controversies surrounding perpetual bonds in the capital market might disappear.