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Primary financial statements

Date recorded:

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:

  • Structure of the statement(s) of financial performance—introduction of an investing category and additional subtotals (AP 21A)
  • Analysis of expenses by function and by nature (AP 21B)

The Staff plan to discuss the following topics at future Board meetings: (a) application of the proposals to other types of entities, e.g. banks; (b) developing guidance on the use of management performance measures and alternative EPS measures; (c) better ways to communicate information about OCI; (d) principles of aggregation and disaggregation, including the need for additional minimum line items; (e) developing illustrative examples/templates for the PFS for a few industries; and (f) targeted improvements in the statement of cash flows.

Structure of the statement(s) of financial performance—introduction of an investing category and additional subtotals – Agenda paper 21A

Background

In this paper, the Staff analysed the concerns raised by the Board members in the June 2017 meeting and refined their previous recommendations.

Staff analysis of feedback received from the June 2017 Board meeting and revised recommendations

1. Prioritising an EBIT comparable subtotal over a management performance measure (MPM) subtotal

At the June 2017 meeting, some Board members were concerned that presenting EBIT and MPM in the same statement could restrict what gets included in the MPM subtotal, given that it appears above EBIT. Furthermore, some Board members had strong reservations about including a non-IFRS measure in the financial statements and according it with GAAP status.

The Staff’s outreach indicated significant support for introducing an EBIT-type comparable subtotal but little support for an MPM subtotal. Accordingly, the Staff recommended that the Board prioritise developing the EBIT subtotal and consider other options for presenting the MPM subtotal later.

2. Introducing an investing category into the statement of financial performance

At the June 2017 meeting, some Board members suggested introducing an investing category into the statement of financial performance to alleviate the problems associated with presenting interest on assets outside capital structure in finance income/expense (e.g. interest income on a financial asset measured at FVTPL), which could be a significant change for some companies. Those Board members also believed that this could help relief pressure on how excess cash and temporary investments of excess cash that form part of an entity’s capital structure is defined. Previously, the Staff proposed using the IAS 7 concept of cash and cash equivalents as a proxy for such excess cash. However, that concept was seen as too restrictive; yet any wider view would inevitably involve management judgement on which assets form part of the capital structure, which would be contrary to the objective of having a comparable EBIT subtotal.

On balance, the Staff supported introducing an investing category above EBIT in the statement of financial performance. They believed that having this category would help users make adjustments to EBIT to exclude investing income/expenses if they wish to do so, because most assets that would otherwise be considered part of the capital structure would likely be investing in nature.

Furthermore, the Staff recommended defining this investing category based on the 2010 Staff Draft of the Financial Statement Presentation exposure draft. In the 2010 Staff Draft, an investing activity was defined as an activity relating to an asset or a liability that:

  • yields a return for the entity—e.g. interest, dividends, royalties, equity income, gains or losses; and
  • does not result in significant synergies for the entity by combining that asset or liability with other resources of the entity.

The Staff believed that this definition is appropriate as it focuses on identifying returns on investments that are separate from an entity’s operations and is expected to capture those assets that are not cash or cash equivalents, but which an entity might consider to be part of the capital structure.

Consistent with having an investing category, the Staff recommended narrowing the definition of finance income/expense to exclude those arising from assets outside the capital structure (as they would generally be captured by the proposed investing category). The revised definition of finance income/expense would consist of the following:

  1. income related to the entity’s capital structure;
  2. expenses related to the entity’s capital structure;
  3. interest income on a net defined benefit asset or a net asset that arises when a liability outside capital structure qualifies for offset with an asset; and
  4. interest expenses on liabilities outside capital structure.

3. Refining the description of ‘investing activities’ in IAS 7

The Staff believed that a distinction should be made between the investing category in the statement of cash flows and the statement of financial performance because they encompass different things. The objective for the investing category in IAS 7 is to identify investments in long-term assets, including investments in debt or equity instruments as well as those that support an entity’s operations (e.g. PPE). However, the related returns from these assets are not necessarily classified as investing activities. Using the same term ‘investing category’ in these two statements will be bound to cause confusion.

Accordingly, the Staff recommended that a different term – investing income/expense – be used for the statement of financial performance to represent the investing category. Furthermore, the Staff recommended changing the term ‘investing activities’ in IAS 7 to clarify that it includes capital expenditure.

4. Using cash and cash equivalents as a proxy for cash and temporary investments of excess cash that form part of capital structure

As noted above, some Board members believed that using cash and cash equivalents as a proxy for excess cash is too restrictive.

On balance, the Staff believed that with the introduction of an investing category in the statement of financial performance, it would be appropriate to continue using cash and cash equivalents as a proxy for excess cash. This is because the investing category will provide greater transparency about income and expenses from investments that are not cash equivalents that an entity might consider to be part of the capital structure. This would enable investors to make adjustments to include other amounts in ‘income/expenses related to capital structure’ if they wish to do so.

5. Renaming the EBIT subtotal

Given the above analysis, the Staff suggested that it may be more accurate to rename the EBIT subtotal as ‘profit before financing and income tax’. This would help remove some of the nuances about what constitutes ‘interest’ (based on the Staff proposal, this includes not only interest but all income/expenses related to capital structure, e.g. foreign exchange gains/losses and fair value adjustments) and ‘tax’ (income tax only, not all taxes) in EBIT.

In addition, they suggested introducing a second subtotal called ‘profit before investing, financing and income tax’ above the proposed investing category.

Discussion

1. Prioritising an EBIT comparable subtotal over a management performance measure (MPM) subtotal

The Board agreed with the Staff recommendation. The Staff confirmed that they will bring back a paper on MPM in the next few months so the intention was not to defer the discussion of MPMs indefinitely or only to circle back at the end of the project.

The discussion also touched on using a columnar approach to present MPMs either on the face of the income statement or in the notes, and on how having a well-explained reconciliation of the IFRS amounts to MPMs surpasses what MPM subtotal the Board ultimately decides on.

2. Introducing an investing category into the statement of financial performance

The Board was generally supportive of introducing an investing category but requested that the Staff redefine the investing category. Some Board members took issue with the reference to ‘synergies’ in the 2010 Staff Draft’s definition as that word is often associated with investments in subsidiaries, associates and joint ventures. Including this term in the definition would have a prima facie impact on where the share of profits/loss from associates and joint ventures should be presented in the income statement. Other Board members were still not clear where various types of finance income or expenses would be located on the proposed new format of the income statement.

The Staff confirmed that they will discuss where the share of profits/loss from associates and joint ventures should be located in a future meeting. They will also try to establish a more concrete objective for having an investing category which should help with developing a definition for it.

As regards the revised definition of finance income/expenses, the Board generally favoured defining it more broadly and keeping the definition to income and expenses related to capital structure with a fuller explanation of what capital structure encompasses. Some members believed that the proposed definition is dicing the ‘I’ in EBIT too finely and point (c) of the proposed definition is an overkill.

3. Refining the description of ‘investing activities’ in IAS 7

There was no discussion on this question given the issues raised above. The Staff will bring back further analysis for future discussion.

4. Using cash and cash equivalents as a proxy for cash and temporary investments of excess cash that form part of capital structure

The Board did not vote on this issue. Their main concern continued to be that some part of cash and cash equivalents necessarily forms part of a company’s working capital float. Treating all of them as capital structure and subtracting all the associated income earned from the ‘I’ of EBIT does not reflect what happens in the real world. The Board acknowledged that this is a simplified proxy for excess cash but rejected it as being far too crude.

The Staff will bring back further analysis for discussion. In particular, they will consider the possibility of including income earned from cash and cash equivalents in the investing category rather than treating them as part of the capital structure.

5. Renaming the EBIT subtotal

The Board did not discuss this issue. The feel around the table was that there was no consensus on any of the core issues discussed above. The Staff will bring back further analysis for future discussion.

Analysis of expenses by function and by nature – Agenda paper 21B

Background

At its March 2017 meeting, the Board asked the Staff to analyse how greater comparability could be achieved for the statement of financial performance by improving the current guidance in IAS 1 on the presentation of expenses by nature or by function. The Staff presented their findings in this paper.

Staff analysis

Feedback from outreach indicated that the following shortcomings in IAS 1 could have contributed to the lack of comparability between entities when presenting expenses in the statement of financial performance:

  1. A lack of description as to what is meant by ‘function’ and ‘nature’. This has led to preparers interpreting these terms differently.
  2. Allowing a choice between two methods of presenting expenses and allowing flexibility on the level of detail of the expense analysis. This has resulted in many entities reporting only the minimum information required by IAS 1, rather than providing more robust details about the entity’s activities. Furthermore, some preparers interpret the choice of presentation as allowing them to present some expenses by nature and others by function. However, feedback from outreach showed that stakeholders would like to retain both methods as each has its merits and one method may be more appropriate than the other in certain industries.
  3. When an entity presents expenses by function on the statement of financial performance, there is limited guidance in IAS 1 on the extent of additional information that is required to be disclosed on the nature of the expenses. The Staff’s research indicated that many entities presenting expenses by function do not disclose information on the nature of the expenses. If such information is disclosed, they are often scattered across several notes.
  4. Allowing flexibility on the location of the analysis of expenses. IAS 1.99 allows entities to present the expense analysis either on the face of the statement of financial performance or in the notes. Users found this troublesome because they cannot obtain a coherent and full analysis of expenses easily which detracts from the usefulness of the financial statements.

Staff recommendation

In light of the above, the Staff recommended that the Board:

  1. describe what is meant by the ‘nature of expense’ method and the ‘function of expense’ method;
  2. retain the choice of analysing expenses by nature or by function, but require an entity to:
    1. use a single method for the analysis of expenses; and
    2. disclose why it has chosen a particular method, including why the chosen method provides the most useful information for that entity.
  3. Require:
    1. the use of the ‘nature of expense’ method when an entity is unable to allocate natural components to the functions identified by the entity on a consistent and non-arbitrary basis;
    2. an entity that uses the ‘nature of expense’ method to provide additional information on the function of expenses if this information is used internally by management; and
  4. require an entity to present:
    1. its primary analysis of expenses (i.e. either by function or by nature) in the statement of financial performance; and
    2. additional information about expenses (i.e. the other presentation option) either on the face of the statement of financial performance or in a single note.

Discussion

The Board approved the Staff’s recommendations subject to the following modifications:

  • On recommendation 2, the Board agreed with retaining the alternatives of presenting expenses either by nature or by function. However, instead of making it a free choice, the Board proposed requiring entities to select the alternative that would provide the most useful information to users. The Board would also provide guidance on how to make that assessment. The Board rejected requiring an entity to explain why it has chosen a particular presentation format on grounds that it would not be meaningful.
  • To include the recommendation in 3(i) as part of the guidance on determining whether presentation of expenses by nature or by function would provide more useful information, instead of having it as a rule-based requirement.
  • The Board rejected recommendation 3(ii) because they saw no convincing reason for providing additional information about the function of the expenses. The Board was not aware of any significant requests for such disclosures and they saw no value in disclosing such information merely for the sake of achieving symmetry with the other alternative (if expenses are presented by function on the income statement, IAS 1 currently requires an entity to provide additional information about the nature of the expenses).
  • On recommendation 4(ii), the Board proposed requiring the disclosure of additional information about expenses in the notes and not to allow a choice between disclosing in the notes or on the face of the income statement. This is on grounds that the primary financial statements are intended to show an overall picture of the company and should appear as uncluttered as possible.

On the issue of whether the Staff should identify additional minimum line items for the income statement, the Board saw that as a step back to the checklist approach and did not support it. Instead, the Board would prefer establishing principles on aggregation and disaggregation, including the development of thresholds to prevent over-aggregation (e.g. the ‘other’ line item should not be more than x% of, say, profit before tax). There was also strong support for developing guidance on how to present disaggregated information on significant functional line items e.g. costs of sales, general and administration expenses, selling and distribution expenses, etc.

Correction list for hyphenation

These words serve as exceptions. Once entered, they are only hyphenated at the specified hyphenation points. Each word should be on a separate line.