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Primary financial statements

Date recorded:

Primary Financial Statements – Cover note – Agenda paper 21

Background

The IASB continued its discussion on the Primary Financial Statements (PFS) project. The topics for this meeting were as follows:

  • Earnings before finance income/expenses and tax (EBIT)—approaches for describing capital structure (AP 21A)
  • EBIT—development of a principles-based approach (AP 21B)
  • Management performance measure (AP 21C)
  • Adjusted earnings per share (AP 21D)
  • Presentation of the share of the profit or loss of associates and joint ventures accounted for using the equity method (AP 21E)

The Staff plan to discuss the following topics at future Board meetings: (a) principles of aggregation and disaggregation, including the need for additional minimum line items; (b) development of illustrative examples/templates for the PFS for a few industries; (c) targeted improvements in the statement of cash flows; and (d) better ways to communicate information about OCI.

Earnings before finance income/expenses and tax (EBIT)—approaches for describing capital structure – Agenda paper 21A

Background

In the papers presented to the Board in the March 2017, the Staff identified that there is diversity in practice as to what constitutes finance income/expenses. They realised that in order for EBIT to serve as a comparable subtotal across entities, there must be consistency in the composition of finance income/expense. In those papers, the Staff preliminarily defined finance income/expense as income/expenses related to an entity’s capital structure. An entity’s capital structure, in the Staff’s view, comprises equity financing, debt financing, as well as excess cash and temporary investments of excess cash (collectively ‘excess cash’). However, what constitutes debt financing and excess cash needed further analysis. This is the focus of APs 21A and 21B for this meeting.

The Staff analysis is intended for non-financial institutions only. The Staff will discuss the application of the capital structure concept to financial institutions at a later stage.

The Staff also noted that they are using the term ‘capital structure’ as a working title for preliminary discussion purposes. They know that this term is widely used in practice with preconceived yet differing interpretations. The Staff will reconsider whether this is the appropriate term once they can pinpoint how to define finance income/expense.

Staff analysis and recommendation

In AP 21A, the Staff recommend that the Board consider what constitutes debt financing by using the IAS 7 definition of financing activities as a starting point. The Board should then refine that definition so that it could be interpreted consistently for the purpose of EBIT presentation (see AP 21B for the proposed refinements).

In terms of the excess cash notion, the Staff believe that it could be represented by ‘cash and cash equivalents’ as defined in IAS 7, with no modifications. The Staff believe that any additions to or subtractions from the defined term (e.g. including other short-term investments or excluding cash that is needed in operations or restricted cash) would increase subjectivity and management judgement. This would in turn detract from EBIT’s ability to serve as a comparable subtotal across entities.

In light of the above, the Staff revised their proposed definition of capital structure as consisting of equity, assets and liabilities arising from financing activities, and cash and cash equivalents.

Discussion

The Board discussed APs 21A and 21B together. No vote was taken on either paper given the many additional issues raised by the Board for further analysis.

The discussion was disjointed. Be that as it may, the Board generally agreed to proceed in the following direction:

  • A principles-based approach will be used to develop the EBIT subtotal.
  • The Board will discuss EBIT and the management performance measure (MPM) together, as opposed to defining EBIT in isolation before moving onto MPM. The Chairman believed that it is important to discuss all the moving pieces together to ensure EBIT and the MPM maintain their complementary roles.
    The Chairman made this comment in response to a Board member’s deep concern that it would be meaningless for the Board to continue discussing the remaining papers when the analysis presented was not sufficient for the Board to make any sensible decisions. It was clear from the discussions at the table that the Board members were not on the same page with regard to what they mean by EBIT, what constitutes finance income/expense, and whether the different types of finance income/expense should be presented above or below EBIT. With many outstanding items yet to be considered for EBIT itself, advancing to a discussion of MPMs would, in that Board member’s view, risk having the Board members ‘leave the meeting more confused than when they arrived’.
  • The Staff should explore the presentation of an investing category in the statement of financial performance, as well as whether that section should be presented above or below EBIT.
  • Using cash and cash equivalents to represent excess cash for the purpose of defining the capital structure is too restrictive. Cash and cash equivalents include only short-term securities and highly liquid investments, whereas the excess cash that is viewed as part of the capital structure would involve much longer term investments.
    The Board asked the Staff to establish a clear principle on what constitutes excess cash and which assets should be included in the capital structure. They should also think through how dividend income and fair value changes of financial instruments measured at FVTPL would fit within EBIT. Furthermore, entities are currently not required to disclose interest incurred or earned separately from the gross fair value movements of financial instruments. Those entities that disclose the interest component separately often do so based on cash flows and not on an EIR basis. If the EBIT proposals ended up requiring such a separation, the Staff should think through the potential standard-setting consequences.
  • Some Board members agreed with presenting the following line items separately above or below EBIT (see AP 21B recommendation (d)):
    • income related to capital structure;
    • expenses related to capital structure;
    • interest income on assets outside capital structure; and
    • interest expenses on liabilities outside capital structure.
    The Board believe that this would alleviate some pressure when defining finance income/expense, because these four lines would give users the information they need to adjust EBIT to suit their own needs.
  • The Chairman also suggested that a discussion paper, and not an exposure draft, be published at the end of the Board’s deliberations. This would give the Board the flexibility to present all the alternative views for comment.

Earnings before finance income/expenses and tax (EBIT)—development of a principles-based approach – Agenda paper 21B

Background

In this paper, the Staff:

  1. proposed clarifications to the current description of financing activities;
  2. attempted to clarify what they mean by ‘income and expenses related to capital structure’; and
  3. refined the definition of finance income/expenses as a result of the recommendations made to date.

Staff analysis

1. Clarifying what constitutes financing activities

This issue was considered by the IFRS Interpretations Committee (IC) in March 2013. The IC concluded that the issue was too big for it to address. The Staff’s recommendation to the IC then was to clarify that the nature of a financing activity involves:

  • (a) the receipt or use of a resource from a provider of finance (or provision of credit);
  • (b) the expectation that the resource will be returned to the provider of finance; and
  • (c) the expectation that the provider of finance will be appropriately compensated through a finance charge.

Based on the above, the Staff believe that the more contentious liabilities e.g. net defined benefit liabilities, decommissioning liabilities, and other long-term provisions such as warranty provisions, would not be considered as financing activities. This is because they do not involve the receipt of a resource from a provider of finance that will be subsequently returned to the finance provider. Accordingly, these liabilities would not form part of an entity’s capital structure. On the other hand, the proposed clarification would include transactions that have been negotiated on extended credit terms, e.g. trade payables and lease liabilities, as financing activities.

2. Income and expenses related to capital structure

At the March 2017 Board meeting, the Staff proposed to define finance income/expenses as income and expenses related to capital structure.

The Staff believe that different criteria should be applied to determine what constitutes ‘income and expenses related to capital structure’ depending on whether the item included in the capital structure relates in its entirety to financing activities.

For example, a bank loan taken out by a non-financial entity would relate in its entirety to financing activities. The Staff believe that all income and expenses related to this loan, e.g. interest, foreign exchange and fair value gains or losses etc. should be included in finance income/expenses. This approach would reduce complexity and the judgement required as regards the nature of an income/expense. It would also align the statement of financial position with the statement of financial performance with respect to what constitutes financing activities.

In contrast, a trade payable with extended payment terms would not relate in its entirety to financing activities because it contains a purchase element. Yet they form part of the capital structure as proposed in point (1) above. Including all income and expenses relating to such a trade payable (e.g. cost of sales) as finance income/expense would obviously be wrong. Accordingly, the Staff believe that the Board should clarify that in such cases, only those income and expenses relating to the funding aspect of the transaction should be included in finance income/expenses.

3. Refining the definition of finance income/expenses

The Staff noted that their proposed recommendations to date would result in the interest on assets and liabilities outside capital structure not being recognised as part of finance income/expenses. For example, as explained in point (1) above, the Staff believe that interest on net on net defined benefit liabilities, decommissioning liabilities and other long-term provisions would not be included in finance income/expenses under the proposed clarifications.

The Staff observe that this would be a significant change from existing practice and might lead entities to presenting an adjusted EBIT to revert to their current practice. This is obviously an unfavourable outcome and the Staff believe that one way of allowing entities to continue excluding interest on net defined benefit liabilities etc. from EBIT is to redefine finance income/expenses.

The revised definition would also view interest on assets and liabilities that are not part of an entity’s capital structure as finance income/expenses. The expanded definition is intended to capture within finance income/expenses interest that is computed as a result of the passage of time from the date of initial recognition of an asset or a liability to the date of its settlement (i.e. interest that did not arise from an explicit funding transaction), in addition to interest that arises as compensation for borrowing funds.

These two types of interests could also be separately presented below the EBIT subtotal so that users have the information at hand should they want to adjust EBIT to suit their own needs.

Staff recommendation

The Staff recommended that the Board:

  • (a) clarify the description of financing activities per point (1) above.
  • (b) clarify that income/expenses related to capital structure include (see point 2 above):
    • (i) all income and expenses on items included in the capital structure that arise solely from financing activities; and
    • (ii) income and expenses related to the funding aspect of items included in the capital structure that do not arise solely from financing activities.
  • (c) define finance income/expenses as (see point 3 above):
    • (i) income/expenses related to the entity’s capital structure; and
    • (ii) interest on assets and liabilities that are not part of an entity’s capital structure.
  • (d) require the separate presentation below EBIT of (see point 3 above):
    • (i) income related to capital structure;
    • (ii) expenses related to capital structure;
    • (iii) interest income on assets outside capital structure; and
    • (iv) interest expenses on liabilities outside capital structure.

Discussion

See the discussion summary on AP 21A. None of the issues in this paper were specifically discussed during the meeting.  

Management performance measure – Agenda paper 21C

Background

In this paper, the Staff followed up on the comments raised by the Board in its March 2017 meeting with regard to the presentation of a management-defined operating performance measure.

Staff analysis

Issue 1— should the Board require the presentation of a Board-defined operating profit subtotal?

The Staff considered but rejected this suggestion mainly because of the many failed attempts in the past to define operating profit. Furthermore, based on outreach performed, the stakeholders supported the presentation of EBIT rather than operating profit.

Issue 2— what constraints should be imposed on items excluded from the management performance measure?

The Staff considered but rejected prohibiting the exclusion of frequently occurring items and items that contradict the Board’s view of operating performance from the management performance measure.

As previously discussed, it would be challenging for the Board to define ‘frequently’ and ‘infrequently’ occurring items. Any flexibility that must necessarily be allowed in their definitions would significantly increase the judgement involved in their application. This prohibition would also prevent entities from showing the performance measures that management use for internal purposes. The Staff rejected the second suggestion relating to the Board’s view of operating performance because that would be tantamount to the Board’s defining operating profit, which the Staff rejected in (1) above. Instead, the Staff suggest addressing the concerns about the presentation of potentially misleading performance measures by improving the transparency of excluded items (see issue 3 below).

The Staff also considered and supported prohibiting the exclusion of items solely because those items are considered to be outside management’s control. They believe that management need to have other reasons when excluding items from the management performance measure, because many income and expenses could be argued as outside management’s control and that would lead to opportunistic exclusions.

Furthermore, the Staff assessed whether the Board should introduce the concept of management-defined constraints. This would involve management defining, for example, what it considers to be performance and what it considers to be an infrequently occurring item. These constraints must then be disclosed, explained and consistently applied. The Staff believe that this transparency would act as a natural deterrent against manipulation and would allow users to judge for themselves whether the management defined parameters are appropriate.

Issue 3— how should an entity present items between the management performance measure and EBIT?

The Staff suggest grouping the reconciling items between the management performance measure and EBIT according to whether they are frequently or infrequently occurring items – these to be defined by management. For infrequently occurring items, the Staff propose requiring additional disclosures in the notes including:

  • (a) a five-year history of the infrequently occurring items;
  • (b) a description of each item excluded; and
  • (c) an explanation of how the items meet management’s definition of ‘infrequently occurring’.

The Staff believe that this would address users’ need to know which income and expenses of the entity are sustainable. It would also allow users to assess whether it is justified to label an item as occurring infrequently.

Issue 4— how should the subtotal be labelled?

Maintaining a consistent flow, the Staff think that the management performance measure should be labelled along the lines of ‘EBIT excluding infrequently occurring items’, and be adapted in cases where frequently occurring items have also been excluded.

Issue 5— should the subtotal be required or allowed?

Given that users are concerned with the lack of transparency in the calculation of performance measures presented outside the financial statements, the Staff believe that the Board should require the same measures to be disclosed in the financial statements. This would subject the calculation of the performance measures to IFRS requirements, as well as to the constraints and disclosure requirements proposed above.

In order to limit the population of the measures to be disclosed, the Staff propose that the Board require an entity to disclose in the financial statements only those measures that are disclosed in the annual report (as defined in the Principles of Disclosures discussion paper).

Staff recommendation

The Staff recommended that the Board:

  • (a) not pursue the development of a Board-defined operating profit subtotal;
  • (b) prohibit the exclusion of an item from the management performance measure solely because the item is considered to be outside management’s control;
  • (c) introduce the concept of management-defined constraints when determining how certain aspects of a management performance measure should be defined;
  • (d) require the reconciling items between the management performance measure and EBIT to be grouped into two separate categories: those that occur frequently and those that occur infrequently;
  • (e) require an entity to label the management performance measure to reflect whether infrequently and/or frequently occurring items have been excluded therefrom; and
  • (f) require, as opposed to permit, an entity to present a performance measure in the financial statements if that measure is disclosed within the annual report (but otherwise outside the financial statements absent this requirement). This is on condition that such a measure does not conflict with the requirements of the Standards.

Discussion

No vote was taken on this paper given the many additional issues raised by the Board for further analysis.

This was another disjointed session in which the Board members proffered various diverging views. There were no specific discussions of the issues presented in the Staff paper. Below are some of the more pertinent comments raised by the Board members:

Abuse of the MPM

A few members (one member was particularly vehement about this) were concerned that elevating the MPM to a GAAP measure could lead to abuse. One member in particular thought that the current requirements in IAS 1.85-85B relating to the presentation of subtotals do not provide sufficient safeguards against entities using MPMs opportunistically. Furthermore, once these MPMs become GAAP measures, they will no longer be subject to the requirements on non-GAAP measures imposed by the regulators. As such, it would be important to communicate with the regulators in this regard and to find solutions to the potential implications.

Subtotal versus reconciliation

Some Board members preferred to present the MPM as a subtotal on the face of the statement of financial performance. However, some other Board members questioned whether it would be better to show the MPM and the reconciliation between MPM and EBIT on a separate statement or in the notes. One member believed that the reconciliation itself as well as the explanations and transparencies offered by the reconciliation are actually more meaningful and useful to users than the final MPM number. Another member disagreed with presenting the MPM as a subtotal because this would restrict what line items could be included in the MPM. For example, net interest on defined benefit plans viewed as finance expense (and so it appears below EBIT) would be structurally restricted from being included in the MPM.

Constraints

Some Board members believed that imposing any constraints on the MPM, be it Board-defined or management-defined, would defeat the objective of using it to tell management’s own story. If any constraints were to be imposed, a Board member suggested using IAS 1.85 as the basis for establishing such constraints. IAS 1.85 requires an entity to present additional subtotals when such presentation is relevant to an understanding of the entity’s financial performance. This Board member suggested that when determining what constraints should be imposed, the Staff should ensure that the proposed constraints would result in a MPM that is more relevant to an understanding of the entity’s financial performance.

Adjusted earnings per share (EPS) – Agenda paper 21D

Background and Staff analysis

This paper follows on the analysis in AP 21C. In this paper, the Staff discuss whether the numerator for adjusted EPS should be calculated consistently with the management performance measure.

In summary, the Staff believe that the users would expect there to be consistency between the management performance measure and the numerator of the adjusted EPS figure because they both purport to present an entity’s performance through management’s eyes. Requiring consistency between the two would also reduce confusion, increase the transparency of how the adjusted EPS is calculated and ultimately its usefulness to analysts. Any difference between the two figures should be clearly reconciled (e.g. the management performance measure is calculated gross of tax and NCI, whereas adjusted EPS is calculated net of them).

It is not clear from the paper though whether the Staff intend for there to be other adjusted EPS figures apart from the one that is ‘calculated consistently with management performance measure’. In some places, the Staff toyed with the idea that such an ‘inconsistently calculated’ adjusted EPS figure could be disclosed in the financial statements despite recommendation (a) below.

Staff recommendation

If an entity presents a management performance measure in its financial statements, and intends to present an adjusted EPS figure, the Staff recommended that the Board require an entity to:

  • (a) calculate adjusted EPS and management performance measures consistently;
  • (b) reconcile any difference between the two amounts;
  • (c) present adjusted EPS in the financial statements if:
    • (i) the entity presents adjusted EPS within the annual report (but otherwise outside the financial statements absent this requirement); and
    • (ii) the adjusted EPS is calculated consistently with the management performance measure; and
  • (d) present the adjusted EPS in the statement of financial performance rather than in the notes.

Discussion

This paper was not discussed due to its linkage with AP 21C and all the outstanding matters that need to be resolved in that paper.

Presentation of the share of the profit or loss of associates and joint ventures accounted for using the equity method – Agenda paper 21E

Background

In this paper, the Staff explore whether the Board should require a specific location for presenting the share of the profit or loss of associates and joint ventures (‘share of investees’ results’ for short) in the statement(s) of financial performance.

Staff analysis

The Staff noted that users commonly exclude the entity’s share of investees’ results from their calculation of key metrics and multiples, and that they analyse the entity’s investments in associates and joint ventures separately from the consolidated group results. Accordingly, the Staff believe that it would be preferable to present the share of investees’ results below the EBIT subtotal.

The Staff then considered whether the share of investees’ results should be presented above or below the income tax expense line. Presenting it below the tax line would be consistent with the fact that the investee’s profits are a post-tax amount. Even though this post-tax amount ignores any additional taxes that may be payable by the entity in relation to the investment, e.g. tax on dividends and other deferred tax implications, the Staff believe that this point alone does not justify presenting the share of the investees’ results above the tax line, which would inappropriately imply that it is a pre-tax amount.

The Staff also considered but rejected allowing or requiring an entity to include the share of investees’ results in the EBIT subtotal, when the associates and joint ventures are integral to the entity’s core operations. The Staff rejected this idea on grounds that it would be difficult to establish what makes an associate or a joint venture integral to an entity. Even if such guidelines were established, it would be difficult to ensure consistency in application. This would undermine the primary objective of using EBIT as a comparable subtotal.

Staff recommendation

The Staff recommended that the Board require the share of the profit or loss of associates and joint ventures to be presented below the EBIT subtotal and below the entity’s income tax expense line item.

Discussion

The Board did not vote on this paper.

Most of the Board members preferred presenting the share of investees’ results above EBIT. They believed that the share of investees’ results is neither interest nor tax so it does not seem right to present it below EBIT.

While some members acknowledged that it would be conceptually good to have flexibility in the placement depending on whether the associate or joint venture is integral to the entity’s operations, it would be challenging to establish a framework on what constitutes an integral associate or joint venture. This option would also represent a change in current practice as the Staff did not come across any such distinction in their review of financial statements, and thus might be difficult to apply.

Another member said where the share of investees’ results is located in relation to EBIT would depend on how the Board define finance expense/income. However, he did not see a reason to put it below the tax line as the share of investees’ results is a pre-tax amount from the investor’s perspective.

Correction list for hyphenation

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