IFRS Archives - Consolidary

We already discussed the draft new standard on Presentation and Disclosures in a previous article on non-GAAP performance measures.

As the comment period on this Exposure Draft will be closing by the end of 2020 (extended deadline due to COVID-19), now is the time to look in more detail at its impact on primary income statement and footnote disclosures.

Introducing Exposure Draft “General Presentation and Disclosures”

*Investors ask for better comparability and disaggregation of financial information*

Having consulted the investor community and hearing their demand for better comparability, improved quality of disaggregation and a connection to non-GAAP performance measures, IASB is proposing new requirements for presentation and disclosure in financial statements. These proposals focus on the P&L but can have a limited impact on cash flow statement and balance sheet as well.

In December 2019, the Board published an Exposure Draft that sets out its proposals for a draft IFRS Standard on presentation and disclosures in financial statements. When finalised, this Standard will replace IAS 1 “Presentation of Financial Statements“.

In this ED the Board proposes:

additional subtotals in the statement of profit or loss.
disaggregation to help a company to provide relevant information.
disclosure of some management-defined performance measures.
limited changes to the statement of cash flows to improve consistency in classification by removing options.

We will discuss the first two of these proposals in more detail below. Please read this article to learn more about disclosing performance measures.

Additional subtotals in the statement of profit or loss

Companies will have to present income and expenses included in P&L in the following categories:

(a) operating – this category includes information about income and expenses from an entity’s main business activities. It should include all income and expenses (included in P&L) that are not classified in one of the other categories.

(b) investing – the objective of the investing category is to communicate information about returns from investments that are generated individually and largely independently of other resources held by an entity. In this category, entities should report income and (incremental) expenses from investments (including non-integral associates and joint-ventures). Note that for companies for which investing is a main business activity (banks), the related income and expense should be reported within the Operating category.

(c) financing – the objective of the financing category is to communicate information about income and expenses from assets and liabilities related to an entity’s financing. That includes income and expenses from cash and cash equivalents and liabilities.

(d) integral associates and joint ventures – defining “integral” as “being integral to an entity’s business activities”, this category includes the reporting entity’s share in the income and expense of integral associates and joint ventures. In practice I would expect that joint ventures are often integral to an entity’s own business activities and associates are not, however that is a choice to be made by each reporting entity. The share in results of non-integral associates and joint ventures goes into the investing category.

(e) income tax

(f) discontinued operations

Acknowledging these categories, the P&L will have to include three subtotals:

*P&L line items and subtotals per ED “General Presentation and Disclosures”*

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.

Note that whilst this third subtotal equals the well-known EBIT measure, the proposal does not include an EBITDA equivalent!

Disaggregation to help a company providing relevant information.

Investors sometimes find it difficult to understand reported information by companies because items may be lumped together without proper explanation. Therefore, the ED includes new guidance to help companies disaggregate information in the most useful way for investors.

How? Well the ED clarifies one more time that:

(a) items shall be classified and aggregated on the basis of shared characteristics;

(b) items that do not share characteristics shall not be aggregated; and

(c) aggregation and disaggregation in the financial statements shall not obscure relevant information or reduce the understandability of the information presented or disclosed.

An entity shall present in the operating category of the statement of profit or loss an analysis of expenses using a classification based on either their nature—the nature of expense method—or their function within the entity—the function of expense method. The entity shall present the analysis using the method that provides the most useful information to users of their financial statements. If a company chooses to present operating expense applying the function of expense method, it will have to add a footnote to provide the operating expense split by their nature.

Further, the ED provides guidance around the aggregation of items that are not material. Either these are aggregated with material items that have the same nature, or they are grouped together with other immaterial items of different natures. In that second scenario, an entity shall disclose in the notes information about the composition of the aggregated items. For example by indicating that an aggregated item consists of several unrelated immaterial amounts and by indicating the nature and amount of the largest item in the aggregation.

*Note disclosure on Unusual Expense, from the Illustrative Examples*

Companies would also be required to provide better analysis of their operating expenses and to identify and explain in the notes any unusual income or expenses, using the Board’s definition of ‘unusual’: “income and expenses with limited predictive value. Income and expenses have limited predictive value when it is reasonable to expect that income or expenses that are similar in type and amount will not arise for several future annual reporting periods.”

These requirements would help investors analyse companies’ earnings and forecast future cash flows.

Process and next steps

During a webcast on 11 February (see below), participants had an opportunity to ask questions to IASB staff members directly.

As said in the introduction, the consultation period on this ED was extended to 31 December 2020. Until then, stakeholders have an opportunity to provide their comments for IASB’s consideration. Given the process, this new standard can be applicable as soon as FY2021!

It’s that time of the year again for closing the books and, very likely, a ritual discussion will take place at many corporate headquarters over the next weeks.

Reporting of performance measures

This debate between management and external audit firm will be around the presentation of the annual results, and it’s one that will not easily be settled. Simply because there’s an implicit conflict of interest: management wants to explain its operational performance and often has to use non-GAAP measures to do so, whilst external auditors need to validate the presentation of financial statements against GAAP Standards such as IFRS®.

As a consequence of this status quo, primary income statements in GAAP financial statements often are a mix of both worlds, confusing investors when they try to compare performance with other companies, and frustrating both management and auditors.

One solution can be to completely disconnect the presentation of formal, GAAP-compliant financial statements from other expressions made by the company around its earnings in its press release.

That however does not help investors to make the connection between management’s comments in press release, and the annual financial statements.

Which complicates the understanding of the company’s performance significantly.

Regulators’ view

ESMA performed a desktop research on 2018 annual financial statements (Management Reports or MR) and ad-hoc reporting (mostly earnings press releases) by 123 issuers to see how companies comply with the rules regarding reporting of “Alternative Performance Measures” (APMs).

Not surprisingly, ESMA concluded that companies use a wide variety of APMs in their financial statements and other reporting. For the most part (around 80%) companies do not sufficiently explain, disclose or reconcile APMs in their financial statements, and ESMA strongly encourages issuers to improve.

One area of attention flagged by ESMA for FY19 reporting is that issuers should properly disclose the impact of changes to the APM used. More specifically the impact of IFRS 16 on APMs such as EBITDA, EBITDAR, CAPEX, net debt or free-cash flow should be clarified by companies!

Standard setters

To address concerns raised by investors, the International Accounting Standards Board (IASB) launched an initiative called ‘Better Communication in Financial Reporting’ some years ago.

As part of that initiative, IASB is looking to replace the existing IAS 1 ‘Presentation of Financial Statements’ with a new IFRS Standard “General Presentation and Disclosures”. The Exposure Draft of this new standard was issued in 2019, with the comment period ending in June 2020 (extended to 30 September 2020 due to COVID-19). The most important elements from the draft Standard are the following:

A. Introduction of 3 subtotals in the income statement to improve the comparability of financial statements:

i. Operating profit or loss;

ii. Operating profit or loss and income and expenses from integral associates and joint ventures (effectively splitting results derived from integral- and from non-integral associates and joint ventures!);

iii. Profit or loss before financing and income tax (EBIT).

B. Introduction of specific footnote disclosure to identify and describe non-GAAP Management Performance Measures. It should include a reconciliation to IFRS sub-totals to help the readers make the bridge between press release and financial statements. Management Performance Measures:

i. are used in public communications outside financial statements;

ii. complement totals or subtotals specified by IFRS Standards; and

iii. communicate to users of financial statements management’s view of an aspect of an entity’s financial performance.

C. Introduction of specific footnote disclosure that identifies and explains certain ‘unusual items of income and expense’ (basically these are non-recurring items) within the primary income statement.

Unusual items have limited predictive value and this disclosure will facilitate building more reliable future expectations by readers. From ESMA’s desktop review, the most commonly adjusted items by companies are the following:

Investors will be able to better understand how- and why management excludes certain one-off elements when it presents its performance measures, and tie them back to the primary GAAP income statement by using the specific footnote disclosures.

What to do for your annual financial statements?

There is a lot of good sense in the IASB proposal. It will allow companies to use relevant performance measures in their financial communication even if those are non-GAAP and exclude certain one-off items.

So even if just a proposal for the moment, you may want to consider organizing your disclosures and communications for FY19 along the lines of IASB’s draft Standard. It will probably avoid painful discussions and certainly help the readers of your financial statements. And that includes your local regulator!

For now I am wishing you a very good and transparent FY reporting!

New IFRS standard in the making – and it will impact the presentation of financial statements!