New financial statements, comments on IFRS project
On 17 December 2019, the IFRS Board published the exposure-draft “General Presentation and Disclosure”. This is the first major step of the “Better Communication in Financial Reporting” project launched some years ago to renew financial communication practices. It focuses on performance reporting (statement of profit or loss and additional measures, including management performance measures) but also proposes changes to the statement of cash flows and the statement of financial position.
At this stage, the exposure draft is only a project, open to comments until 30 September 2020 (the previous deadline – 30 June – has been delayed due to the Covid-19 pandemic); it may be adopted as it is or deeply modified after feedback is received. However, the Board’s proposals are really innovative and may significantly affect companies’ practices if adopted, especially as regards performance measures. As a consequence, it seems interesting to question how companies could face these changes, if so, and how they would have to adapt their systems, especially in the consolidation area, to comply with these new requirements.
The exposure draft applies to all companies whatever their activities. However, in this document, we do not address specific provisions for banking and insurance companies that may be significantly different as regards the presentation of financial statements.
Summary of main proposed changes
The exposure draft proposes a new structure for the statement of profit or loss, that would be divided in four categories. New subtotals would be required, as shown in the following template (exposure-draft, page 7).
Integral and non-integral associates and joint ventures
Associates and joint ventures are (and will continue to be) accounted for using equity method. The exposure draft proposes to define which of them are “integral” and which are not, and to present separately the figures related to one or the other category in the statement of profit or loss, as well as in the statement of other comprehensive income, the statement of financial position and the statement of cash flows.
Companies that present expenses classified by function in the P&L would be required to disclose in a single note an analysis of their total operating expenses by nature. Unusual income and expenses, although presented together with “usual” items in their respective categories in the P&L, would be separately identified and disclosed in a single note.
As regards the balance sheet, companies would be required to present goodwill separately from other intangible assets.
Most companies communicate performance measures defined by management but rarely provide a detailed reconciliation with IFRS figures. The Board proposes to include these measures in the financial statements through a single note. Mandatory disclosures would include a description of how each measure is calculated and a reconciliation between each measure and the most directly comparable subtotal or total specified by IFRS.
The Board proposes to require operating profit as the single starting point for the indirect method in the statement of cash flows. This would be a major change for most companies that currently use net profit as a starting point.
It also proposes to reduce the presentation alternatives currently permitted by IAS 7 as regards interests and dividends.
The exposure draft proposes to classify income and expenses in the following categories:
- integral associates and joint ventures,
- income tax,
- discontinued operations.
Whereas no subtotal is currently required, the new proposed standard would require the following ones to be presented:
- operating profit or loss,
- operating profit or loss and income and expenses from integral associates and joint ventures,
- profit or loss before financing and income tax,
- profit or loss
The operating category would include all income and expenses relating to an entity’s main business activities. In the exposure draft, this category is defined as a residual: all income and expenses that are not classified in the other categories would fall into the operating category.
Additional guidance is included regarding some categories of income and expenses:
- Foreign exchange differences should be included in profit or loss in the same category of the statement of profit or loss as the underlying transaction. For example, foreign exchange differences relating to revenue would be classified in operating whereas those on foreign currency denominated loans would be classified in financing.
- Income and expenses from investments made in the course of an entity’s main business activities would be classified in operating profit. This would be the case, for example, for income and expenses relating to property, plant and equipment (including gain or loss on disposal or impairment losses).
- Interest revenue from trade receivables would be classified in the operating category.
- Gains and losses on hedging instruments are classified according to the risks they are intended to hedge, for example in operating if they manage risks affecting income or expenses classified in the operating category. Gains or loss on derivatives that are not used to manage risks are classified in the investing category.
In the operating category, expenses would be classified by nature or by function. But, compared with the current IAS 1, entities would have to apply the method that provides the most useful information and a mix of both methods would no more be allowed. Furthermore, entities that use the function of expense method would have to disclose in a single note a comprehensive analysis of operating expenses classified by nature.
See next part for the definition of integral and non-integral associates and joint ventures.
Income and expenses from integral associates and joint ventures would include:
- the share of profit or loss of integral associates and joint ventures,
- impairment losses and reversals of impairment losses on integral associates and joint ventures,
- and gains or losses on disposals of integral associates and joint ventures.
The investing category would include income and expenses from investments that are not part of the entity’s main business and incremental expenses related to those investments (meaning expenses that the entity would not have incurred had the investment not been made).
This category would include income and expenses from financial assets, except for cash and cash equivalents, such as interest revenue, impairment losses and reversals of impairment losses, gains and losses on disposal, fair value gains and losses, dividends and the share of profit of non-integral associates and joint ventures. It would also include income and expenses, gains and losses on investment property except when these investments are made in the course of the entity’s main business activities.
The investing category in the statement of profit or loss is different from investing activities in the statement of cash flows. All investments made in long-term assets are classified as investing activities in IAS 7, including operating assets such as property, plant and equipment. Cash flows related to such assets are classified in investing in the cash flow statement whereas income and expenses (including gain or loss on disposal) would be part of operating profit in the proposed statement of profit or loss.
The financing category would include:
- income and expenses arising from financing activities (e.g. interest expenses on a bank loan or long-term trade payables, fair value gains and losses on a liability designated at fair value through profit or loss);
- income and expenses from cash and cash equivalents;
- interest income and expenses on liabilities that do not arise from financing activities (e.g. net interest income or expense on employee benefit plans or unwinding of the discount on long-term provisions).
Cash and cash equivalents are defined in IAS 7. They comprise cash on hand, demand deposits and short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Bank overdrafts are included as a component of cash and cash equivalents if they form an integral part of an entity’s cash management. It should be noted that income arising from short-term investments that do not meet the definition of cash equivalents would be classified as investing whereas those that meet the definition of cash equivalents would be classified as financing.
If an entity provides financing to customers as a main business activity, it would have to make an accounting policy choice between classifying in the operating category:
- only income and expenses that arise from financing category and income and expenses from cash and cash equivalents relating to its provision of financing to customers; or
- all income and expenses from financing activities and all income and expenses from cash and cash equivalents.
The Board proposes to classify equity-accounted associates and joint ventures either as integral or non-integral.
Integral associates and joint ventures are defined as those that are integral to the main business activities of the group and that, consequently, do not generate a return individually and largely independently of the other assets of the group.
Examples of a significant interdependency include:
- having integrated lines of business with the associate or joint venture;
- sharing a name or a brand with the associate or joint venture;
- having a supplier or a customer relationship with the associate or joint venture that the group would have difficulty replacing without significant business disruption.
Impact of equity-accounted entities on the group’s financial statements would be presented separately depending on whether they are classified as integral or non-integral, in the statement of profit or loss, in the statement of other comprehensive income, in the statement of financial position and in the statement of cash flows (dividends received).
The exposure-draft proposes to amend the current standard (IAS 7) regarding the cash flow statement presentation.
First, it would require using the operating profit or loss subtotal as the starting point for the indirect method.
As a reminder, IAS 7 allows companies to present operating cash flows using either direct method or indirect method. In the direct method, major classes of gross cash receipts and gross cash payments are disclosed: cash receipts from customers, cash paid to suppliers, … In the indirect method, profit or loss is adjusted for the effects of transactions of a non-cash nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows.
Most companies currently use the indirect method starting from the net profit or loss. Changing this starting point for the operating profit or loss would require a significant effort.
Secondly, the current version of IAS 7 allows companies to choose where interests and dividends, paid or received, are classified (operating, investing, financing). The exposure draft proposes to require presenting interests and dividend paid as financing cash flows whereas interests and dividend received would be classified as investing.
Companies would be required to present goodwill separately from other intangible assets. They would also have to present investments in integral associates and joint ventures separately from investments in non-integral associates and joint ventures.
Unusual income and expenses are income and expenses with limited predictive value. It means that the company does not expect that similar (in type or in amount) income or expenses will arise for several future annual reporting periods. Examples given are an impairment loss resulting from a fire or high litigation costs (unusual by amount).
The Board proposes that these unusual items remain presented together with “usual” items in their respective categories in the P&L. However, a single note would include all information about unusual income and expenses including the lines items of the P&L in which they are included.
Management performance measures are subtotals of income and expenses that:
- are used in public communication outside financial statements;
- complements totals or subtotals specified by IFRS standards; and
- communicate to users of financial statements management’s view of the entity’s financial performance.
This definition is limited to subtotals of income or expenses (such as EBIT or EBITDA); other financial measures, such as currency adjusted revenue or return on capital employed, are not regarded as management performance measures and are therefore excluded from the scope.
The exposure draft proposes that all information regarding management performance measures should be provided in a single note. It would also specify the information to be disclosed, including a reconciliation to the most directly comparable total or subtotal specified by IFRS standards.
If the exposure draft is adopted, companies may have to significantly adapt their reporting systems. The amount of effort will depend on the presentation of financial statements they currently use. However, for all of them, provided they have equity-accounted entities, the question of identifying integral and non-integral associates or joint ventures would arise.
As explained above, classification as integral or non-integral depends on the interdependency between the group and the equity-accounted entity. It will therefore require management judgment to operate this classification. In other words, it cannot be automated on the basis of quantitative thresholds.
However, once this classification is done, it will be necessary to flag differently these two categories in the consolidation system to automate the production of the financial statements. Indeed, though the accounting method is the same for both, they will affect different lines in all financial statements.
Statement of financial position
The statement of financial position, or balance sheet, is little affected by the project. The exposure draft only proposes to require that goodwill should be presented distinctly from the other intangible assets. As goodwill is usually recorded in a dedicated account, this proposal would generally not require much effort to be applied.
Statement of financial performance
The exposure draft proposes a normalized – and mandatory – structure of the statement of financial performance, or statement of profit or loss. The current version of IAS 1 requires some mandatory line items but does not require the presentation of subtotals. Consequently, the structure and content of the statement of profit or loss varies between companies, even though most of them present distinctly an operating subtotal (whose content may be different). The proposed classification would require significant changes from most companies. In addition to the matter of integral or non-integral associates and joint ventures, the classification of non-operating items either in investing or in financing may be challenging.
Beyond the presentation itself, some revenue and expenses would have to be classified differently and, for some of them, split between categories. For example, foreign exchange differences would have to be included in the same category as the underlying transaction whereas the classification currently derives from the company’s accounting policy. Some choose to present all foreign exchange gains and losses in other operating gains or losses or in finance costs.
As a consequence, the proposed changes would not only require to modify the structure of the statement of financial performance but also may have an impact on the chart of accounts.
Statement of cash flows
Most companies currently use net profit or loss as the starting point of the statement of cash flows. As net profit or loss is a component of the balance sheet (whether presented separately or included in retained earnings), it makes it possible to automate the production of the cash flow statement using movements of the other balance sheet accounts. If the exposure draft is adopted, the starting point would be the operating profit. It would make the automation far more complicated as operating profit is a subtotal of profit or loss that does not correspond to a specific movement in the balance sheet. This would require significant changes in the consolidation system: new calculation principles to automate the production of cash flows as a minimum and probably changes in the chart of accounts to track information needed.
In contrast, the new classification principles that would normalize the presentation of dividends and interests would not require much effort.
The new proposed requirements regarding disclosure of unusual income and expenses would make it necessary to identify these items that are classified together with the usual income and expenses in the profit or loss statement. It may be possible to create dedicated accounts (e.g. unusual employee benefits) but it would significantly increase the number of accounts. Other tracking solutions may be considered.
As regards management performance measures, they are usually monitored in reporting systems. However, they are not always reconciled with statutory figures which would become mandatory.