The Gearing Adjustment

We have seen that the capital structure of a company has important implications for financial management purposes. In particular, the gearing is important, since it expresses the relationship between fixed interest (loan capital) and fixed dividend (preference shares) to ordinary shares. A company that has a large proportion of fixed interest and fixed dividend bearing capital to ordinary capital is said to be highly geared.

The purpose of the gearing adjustment is to allocate equitably the current cost adjustments in order that the full burden should not fall on ordinary shareholders, where they themselves have not financed the entire assets in respect of which the adjustments are made. This adjustment, subject to interest on borrowing, indicates the benefit or cost to shareholders which is realized in the period, measured by the extent to which a proportion of the net operating assets are financed by borrowing. The current cost profit attributable to shareholders is the surplus after making allowance for the impact of price changes on the shareholders' interest in the net operating assets, having provided for the maintenance of lenders' capital in accordance with their repayment rights.

SSAP 16 requires a gearing adjustment to be made where a proportion of the assets of the business is financed by borrowing. Net borrowing is defined as the amount by which liabilities (defined in (1) below) exceed assets (defined in (2) below):

(1) the aggregate of all liabilities and provisions (including convertible debentures and deferred tax but excluding dividends) other than those included within monetary working capital;

(2) the aggregate of all current assets other than those that are subject to a cost of sales adjustment and those that are included within monetary working capital.

The gearing adjustment itself results from the application of the gearing ratio to the net adjustments made in converting the historical cost income to current cost income. The gearing ratio is found in the relationship between net borrowing (L) and the average ordinary shareholders' interest obtained from the opening and closing balance sheets (S), as follows:

Gearing ratio = L � S

The gearing adjustment has been the subject of considerable controversy. Everyone would agree that during inflation shareholders benefit from long-term loans, as their repayment is ultimately made in monetary units of smaller purchasing power. Whilst the gearing adjustment appears to be more acceptable than a current purchasing power adjustment, it is less clear why the gearing ratio should be applied to the current cost adjustments rather than to the entire increase in net asset values. SSAP 16 recognizes this controversy and states that:

'There are a number of possible methods for calculating a gearing adjustment. For the reasons set out it is believed that the method defined in the Standard is the most appropriate and, on the grounds of the need for comparability between company accounts, it has been made definitive. This does not prevent those who wish to show in addition the effect of a different method of calculating a gearing adjustment from doing so by way of a note to the accounts. It would help users if those adopting this course explained their reasons for so doing.'


For More Information On Bank Reconciliation Statements

Read on: The Cost of Sales Adjustment (COSA)

The cost of sales adjustment refers to the difference between the current cost of inventories at the date of sale and the amount charged as the cost of goods sold in computing the historical cost profit. As we shall see in Part 5, business enterprises use standard costing systems for the purpose of obtaining timely information about the cost of inventories. These standard costing systems are designed to identify and to reflect, inter alia, changes in the current cost of purchased inventories. Where a standard costing system is in use, it is possible to derive an analysis of the variances which are... see: The Cost of Sales Adjustment (COSA)