CURRENT STATE OF PRESENTATION CHOICES FOR FINANCIAL PERFORMANCE
The International Accounting Standards Board (IASB) initiated a project on primary financial statements in June 2015 as part of IASB’s plan to promote better communication in financial reporting. Stakeholders have expressed strong demand for IASB to undertake a project to improve the reporting of financial performance. Hence, in a bid to improve comparability and transparency of performance reporting, the Board is proposing to issue a new standard to replace International Accounting Standard (IAS) 1 Presentation of Financial Statements with new requirements on presentation and disclosures in the financial statements, particularly the statement of financial performance.
CURRENT REQUIREMENTS UNDER IAS 1
IAS 1 paragraph 81A requires an entity to present profit or loss. There is, however, no requirement to present other specific subtotals.
IAS 1 paragraph 82(c) requires presentation of the share of profit or loss of associates and joint ventures as a separate line item in the statement of profit or loss but does not specify its location in the same statement.
IAS 1 paragraph 99 requires an entity to present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function, whichever provides information that is reliable and more relevant. In addition, paragraph 104 requires entities classifying expenses by function to disclose additional information on the nature of expenses.
THE BOARD’S PROPOSAL
IASB recently issued the Exposure Draft on General Presentation and Disclosures (ED) in December 2019 with a call for comments that is due 30 June 2020. In brief, there are three key proposals requiring entities to:
- present new defined subtotals in the statement of profit or loss,
- disaggregate information in a better way, and
- disclose information about performance measures defined by management.
We will focus on the first two proposals in this article as we study the current state of presentation of entities relating to these two proposals.
The first proposal arises because investors want subtotals in the statement of profit and loss to be comparable between entities. The lack of requirements for subtotals in the current IAS 1 results in diversity in the structure and content of the statement of profit or loss. For example, many entities report operating profit in the statement of profit or loss. However, there is a diversity of definitions of operating profit and this makes it difficult for investors to compare financial performance across entities, even within the same industry.
IASB is proposing that entities present three subtotals thus creating four defined income/expense categories. The subtotals are, namely, (i) operating profit, (ii) operating profit and income and expenses from integral associates and joint venture, and (iii) profit before financing and income tax. The four categories are, namely, (i) operating, (ii) integral associates and joint ventures, (iii) investing, and (iv) financing. Category (ii) recognises that entities may be invested in associates and joint ventures that are closely related to the entity’s main business activities while investing category (iii) is a category that reflects returns from “standalone” investments.
The second proposal requires entities to present in the statement of profit or loss, an analysis of operating expenses using the method (by nature or function) that provides the most useful information to investors. If the function method is used, entities are required to disclose in a single note an analysis of their total operating expenses by nature. This proposal arises because investors have expressed concerns that useful information is lost because entities may not choose the method that provides the most useful information. Furthermore, some entities insufficiently disaggregate information. Functional line items aggregate “expense items with different natures that respond differently to changes in the economic environment” (ED Basis of Conclusions (BC) paragraph BC111), which in turn makes it difficult for investors to forecast future operating expenses.
IASB is also proposing to define unusual income and expenses as “income and expenses with limited predictive value”. Entities present these items together with “usual” income and expenses in their respective categories in the statement of financial performance and are required to supplement with detailed disclosures. BC paragraph 56 states that predictive value is not a characteristic that differentiates whether income or expenses are operating (or any category). The separate identification with supporting disclosure of such unusual items will be helpful for investors when predicting the entity’s future cash flows. Currently, some entities disclose unusual (or similarly described) expenses and income. However, it is unclear how these items have been identified as unusual and the supporting disclosures vary significantly.
A LOOK AT THE STRAITS TIMES INDEX TOP 30 COMPANIES
We examine a sample of companies to see how companies are making their presentation choices in the statement of financial performance. We obtain a list of the top 30 companies listed on the Singapore Exchange that make up The Straits Times Index. We review one year of annual reports of these 30 companies with financial year ending between 30 June 2018 and 31 March 2019. Of the 30 companies, 26 are non-financial companies and four are financial companies.
First, we examine whether entities report an “operating profit” (or similarly described) subtotal. Twenty-one (including three financial companies) of the 30 entities report operating profit in the financial statements. The most common term used to describe “operating profit” is inevitably “Operating profit” (16 entities). Others include “Profit from operations” (two entities), “Profit from operating activities” (two entities) and “Profit before income tax and non-operating items” (one entity).
Various definitions of operating profit are used. One entity defines operating profit as representing “recurring earnings”. Others may choose to either include or exclude interest income and finance costs, gain or loss from disposal of fixed assets and impairment losses. Table 1 shows the number of non-financial entities that include these items in operating profit, and different combinations exist. These point to clear diversity in the current presentation of statements of profit or loss.
Table 1 Determination of operating profit (for non-financial entities)
Most entities are, however, consistent in excluding share of profit in associates and joint ventures in operating profit. Only one entity out of the 21 entities includes the share of profit in associates and joint ventures in operating profit.
Second, we examine the disclosure of operating expenses and whether the disclosure by nature is complete. Table 2 summarises the findings.
Table 2 Disclosure of operating expenses
Sixteen entities present expenses by function, while 14 entities present expenses by nature in the statement of profit or loss. Five entities in the former group provide detailed breakdown of the expenses by nature in their notes and the total expenses by function can be tied back to the total expenses by nature. For the 14 entities that present expenses by nature, six entities provide detailed breakdown of these expenses and the subtotal in these notes can be tied to the total expenses presented in the income statement.
Of the 19 entities that do not provide a complete analysis of the expenses by nature, the proportion of expenses without information on their nature averaged more than 25% (with median at 19%). Firms that present expenses by nature tend to use broad categories like “other operating expenses” and the supporting disclosures generally cannot be tied to the total expenses presented in the income statement. Clearly, more disclosures required by the ED with respect to expenses disclosure will support the forecasting needs by investors.
As for the current state of presentation/disclosure of “unusual items”, two entities use the phrase “Exceptional items” on the income statement, with one entity excluding it from operating profit (for impairment loss on property, plant and equipment) while the other entity includes the exceptional item (for restructuring expenses, gain on disposal of fixed assets and investments and dispute settlement) in the determination of operating profit. The lack of supporting disclosure makes it difficult for users to assess if these items are not expected to arise for several future periods.1
The findings in this article show that under the current requirements of IAS 1, there exists diversity in the structure and content of the statement of profit or loss. Many entities choose to report operating profit but the diversity in the definitions of operating profit reduces the usefulness of this subtotal. Furthermore, the findings also show that many entities provide incomplete disaggregation of their operating expenses by nature. IASB’s proposal to require companies to present new defined subtotals in the statement of profit or loss will result in a more standardised statement of financial performance. This will increase the comparability of financial performance both within the same industry and over different industries. The Board’s proposal to require entities to disclose an analysis of their total operating expenses by nature (with unusual items separately disclosed) is likely to provide a better basis for investors when forecasting future operating expenses.
Patricia Tan Mui Siang is Associate Professor of Accounting, Nanyang Business School, Nanyang Technological University, and Koh Wei Chern is Associate Professor, Accountancy Programme, School of Business, Singapore University of Social Sciences.
1 One other entity states that there is a “one-off financial penalty & related costs” on its income statement. For this entity, it can be assessed that this item will not be expected to arise in future periods.