FASB Research — Cover Memo — Agenda paper 28

This was an educational session in which the FASB staff provided the Board with an update on the research it has performed in the FASB’s financial performance reporting (FPR) project. The FPR project was undertaken in response to stakeholders’ repeated requests for greater granularity of performance information to be disclosed in the financial statements. Accordingly, the FPR project focuses on finding ways to improve the following aspects:

1. Disaggregation of performance information; and
2. The structure of the income statement.

The Board was asked to comment on the FASB’s staff analysis. The Board was not asked to make any technical decisions.

Topic 1: FASB Research — Disaggregation of Performance Information — Agenda paper 28A

FASB’s staff analysis

The staff’s research findings indicated that the problem of over-aggregation seems to be concentrated in income statement line items presented by function. The staff proposed four alternatives in which more disaggregation could be achieved. These alternatives have been considered by the FASB and were included in the document Invitation to Comment: Agenda Consultation (ITC) published by the FASB in August 2016. On balance, the FASB prefers alternative 3 below.

Alt 1: To provide principles-based guidance on how to aggregate performance information

Under this alternative, the staff proposed to:

1. describe the processes of aggregation and disaggregation when disclosing performance information;
2. describe the two classes of lines (i.e. disaggregation by nature or by function) and the aggregation characteristics relevant to the performance statement; and
3. discuss the order in which the aggregation characteristics should be applied.

The FASB noted that the proposals are too principles-based and not necessarily helpful for preparers and practitioners. They also noted that the discussion on disaggregation by nature or by function is similar to the proposals in alternative 3.

Alt 2: To standardise what is meant by ‘infrequent’ items

Under this alternative, the staff proposed to:

1. redefine the frequency of occurrence of a transaction as being relative to the recognition of similar transactions over time, and that it is not simply characterised by whether a transaction happens often or rarely;
2. lower the current threshold in US GAAP for identifying an item as infrequent to the level of ‘non-routine’ transactions; and
3. require separate disclosure of infrequent items.

Although there was some support for this alternative, some FASB members observed that lowering the infrequency threshold would require management to exercise additional judgment which might add to the cost of financial reporting and aggravate disputes between auditors, preparers, and regulators. A few ITC respondents noted that no matter how the FASB redefines infrequency, outcomes will differ across entities.

Alt 3 (preferred alternative): Disaggregating line items presented by function into components by nature

Under this alternative, the staff proposed to:

1. clarify that items can be presented on the face of the income statement either by nature or by function;
2. describe the characteristics (or traits) that items must share in order to be grouped by nature;
3. describe a functional line as displaying the activity from which an item arises, e.g. cost of goods sold, selling expenses etc.
4. require the disaggregation of a functional line into components by nature either on the face of the income statement or in the notes.

The FASB preferred this proposal above the others because they generally agreed that over-aggregation is concentrated in functional lines. Nonetheless, the FASB acknowledged that there will be challenges to develop this proposal further, particularly how to define a ‘functional’ or ‘natural’ line, and how to deal with costs that lose their identity. The latter could arise from recharges for inter-departmental services (e.g. department A incurs salary, rent and other costs to provide advertising services to department B, and charges B a lump sum for the advertising service. The costs incurred by A lose their nature through the recharge process), or from capitalising expenditures, such as labour costs that are capitalised into inventories which then gets expensed as cost of goods sold.

Alt 4: Requiring the disclosure of certain minimum information

This alternative was not explored further by the staff due to a lack of conceptual basis for requiring minimum information that could be meaningful to all entities. The FASB acknowledged the challenges encountered by the staff.

The FASB staff have also taken note of the IASB’s Primary Financial Statement (PFS) research project. They await the IASB’s further analysis on the following aspects of the project:

• What characteristics will the IASB identify as a basis for aggregation? How will the IASB decide whether or not, and if so, how, to prioritize those characteristics for the purposes of aggregation and disaggregation?
• How will the IASB approach requiring a ‘recurring operating profit’ subtotal in the income statement and defining the concept of infrequent amounts?
• If the IASB decides to publish industry templates for the structure of the income statement, what will be their rationale for whether the line items should be defined by IFRS or by management, and whether the performance information should be disclosed on the face of the income statement or in the notes?

Discussion

The FASB Staff reiterated throughout the discussion that they are still at a preliminary stage of exploring the alternatives listed in the paper (which are by no means exhaustive), and that they can foresee significant challenges with proceeding with any of them. The Chairman of the IASB noted that the IASB staff encountered many of the same challenges in their PFS project. The discussion focused on alternatives 2 and 4.

As regards alternative 2 on infrequent items, some IASB members found the distinction between infrequency of amounts and infrequency of occurrence confusing. The FASB staff explained that they conceive infrequency of amounts as a threshold for disclosure, e.g. anything above 10% of net income is infrequent, but they rejected proceeding with this concept as they wanted to avoid setting any arbitrary bright-lines for disclosures. They also admitted not knowing how to proceed with setting out the conceptual foundation for disclosing infrequent amounts. Nevertheless, the FASB staff noted that users would normally be able to identify abnormal amounts through trend analysis over time. They also admitted that they have not thought through how to classify an infrequent amount arising from a frequent transaction.

A couple of IASB members took issue with describing a frequent items as something that ‘could have been reasonably anticipated’. They believed that whether something is anticipated would depend on the size of the company, which should be the first point of consideration under this alternative. This is because for a relatively big company, minor litigations and asset disposals are likely to occur every year, which is not so for smaller companies. Furthermore, they questioned whether events like impairment – that are budgeted for but once-off – should be classified as frequent or infrequent. Ultimately, what users want to avoid is surprise, so the IASB member believed that if the event is known or expected, then it should not be classified as infrequent.

The FASB staff also mentioned that whether items are presented on the face of the income statement or in the notes is not so relevant anymore in the digital world. This is because the items are tagged and users can easily find what they want. Nevertheless, the staff admitted that the time lag between results announcement, which usually includes only the primary financial statements and a few notes, and when the full set of financial statements is made available could still impact the consideration of where information is disclosed.

In terms of alternative 4 on the requirement for minimum line items, the FASB staff noted that there is a surprising level of consistency within the same industry on line items presented by nature. They believed that this could have resulted from industry-specific regulations. Nevertheless, the FASB staff noted that they would unlikely require industry-specific minimum line items as their focus is on requirements that are applicable to all entities. The FASB staff also confirmed that their proposals for minimum line items were developed in terms of what is best for US GAAP without regard to how they would interact with regulations. As part of the exchange of views, the IASB Staff acknowledged that they will have to explore further on how the proposed industry specific templates would apply to conglomerates.

As to alternative 1, one of the IASB member shared the FASB’s concern that the approach is too conceptual and that it would be difficult to apply in practice. The FASB staff also admitted that they have not considered whether there would be any practical difference in outcome between an aggregation approach versus a disaggregation approach to disclosing information. 

Topic 2: FASB Research — Structure of the Performance Statement — Agenda paper 28B

FASB’s staff analysis

The respondents to the FASB’s August 2016 ITC and the FASB itself have mixed views in whether and, if so, what types of improvements to the structure of the performance statement are needed. This ranges from holistic structural improvements to the entire performance statement, to focused improvements to the profit or loss section only, to not standardising the structure of the income statement at all.

Those who support having some form of definition of operating activities and requiring the presentation of an operating performance measure in the income statement believe that making it a US GAAP requirement would add discipline to the process through the audit function. It would also require restatement of comparative information if there is a change in the composition of the performance measure.

Those who do not support defining operating activities or structuring the income statement pointed out that the FASB has previously undertaken various failed attempts at restructuring the income statement. Without a robust and comprehensive conceptual basis for reorganising the income statement, as well as what is meant by operating activities, any attempt at this project will likely be met with fierce resistance. Furthermore, supporters of this view believed that given the significant differences across industries, no single set of line items or subtotals would serve all entities equally well. Besides, the voluntary practice of presenting operating performance is fairly developed in the US, which has coalesced into what items are generally included or excluded in operating income for different industries. Moreover, any project on restructuring the income statement should involve a much deeper analysis of cross-cutting issues such as where the changes in the carrying value of liabilities should be recognised, rather than merely dumping all volatilities in OCI. Instead of restructuring the income statement, the supporters of this view believed that it is more important to have more disaggregated information of the income statement line items so that users can perform their own calculations.

Despite the above, the FASB staff has proposed the following six alternatives for the structure of the performance statement:

1. Defining what is meant by ‘operations’ or ‘operating activities’, by defining what is included in it, what is excluded from it, or defining the term by broad industry groupings;
2. Describing, as oppose to defining, what is meant by operating activities and establishing parameters for interpreting the meaning of operations. Management would determine the composition of that measure through an accounting policy;
3. Requiring the presentation of an operating or an intermediate performance measure. This could either be management-defined or be based on the measure the entity uses to communicate its performance to internal and external stakeholders;
4. Including guidance in each section of the Accounting Standards Codification as to whether certain items should be included in, or excluded from, operating profit;
5. Defining operating activities as: revenue less cost of goods sold less selling and administrative expenses, similar to the approach used in Korean IFRS. Management will be allowed to define the composition of each element of the formula; or
6. Defining common non-GAAP subtotals, such as EBIT or EBITDA. The FASB would define the composition of interest income, interest expenses and tax expense.

The staff also analysed the merits and potential challenges of each of the above alternatives in the agenda paper.

With regard to the IASB’s PFS project, the FASB staff are particularly interested in the following:

• How will an EBIT subtotal apply to entities whose activities are concentrated in financial instruments, such as banks, insurers, and conglomerates?
• How will the IASB distinguish debt finance and operating finance interest expense? and
• If the IASB decides to require an operating performance measure, what kind of parameters will the IASB put around it and how will the IASB enhance the consistency of this measure across entities?

Discussion

The FASB staff noted that regulations have most likely played a role in entities using a consistent description of the ‘operating income’ subtotal and what is included and excluded from that subtotal. They also noted that the presentation of operating income does not necessarily reduce the presentation of non-GAAP measures in the annual reports, albeit outside the financial statements, e.g. in the MD&A.

Throughout the discussion on which types of operating performance measures should be presented in the income statement, the FASB staff emphasised the need to develop a robust conceptual basis for the measure that is proposed for inclusion in order to achieve consistency across entities and be meaningful to users. They also acknowledged the challenge on defining what constitutes operating activities and that it would be a complex undertaking for the FASB if they were to proceed with this approach. The FASB Staff also doubted the usefulness of requiring a management-defined performance measure without specifying what it should include or exclude.

One IASB member was particularly critical of the perceived complexity in classifying interest as operating or non-operating for the purpose of EBIT and EBITDA presentation for financial institutions. He believed that it could be a relatively simple assessment for entities to determine whether interest income and expense are part of their core revenue-generating activities and this judgement is not vastly different from any other judgements that management have to make in preparing financial statements. The FASB staff acknowledged his rebuke but noted that the challenge is how to change stakeholders’ perception and to overcome the established practice.

With regard to section 3 of the staff paper, which covered the feedback received from the ITC and the FASB February 2017 meeting, the Chairman of the IASB acknowledged the polarised views expressed by the different stakeholder groups but none of the IASB members made any further comments on it.