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Primary financial statements

Date recorded:

Classification of income and expense by financial entities (Agenda Paper 21A)

Background

This paper addresses some Board members’ suggestions and further refining of the scope of proposals for required subtotals in the statement(s) of financial performance as previously discussed at the September 2018 meeting.

Staff analysis

A. Which income and expenses should be classified in operating profits?

The staff believe the Board should require all entities to apply the model for general corporates (‘general model’) then consider any exceptions or exemptions from the model for financial entities. The staff suggested that that classification requirements which result in useful information should not be optional but rather a requirement and entities should not be required to allocate income and expenses when the basis for allocation is arbitrary or the costs would outweigh the benefits.  

B. Should there be further exceptions or exemptions to the general model?

The staff have considered providing specific exceptions or exemptions for entities which provide both financing to customers and invest in the course of their main business activities and allowing entities whose largest activity is to provide financing to customers to include all expenses from financing activities and income from cash and cash equivalents in operating profits. However, the staff rejected both approaches as these approaches would either result in the costs outweighing the benefits or result in exclusion of the entities that the Board would like to capture.

C. What does the new classification model for financial entities mean for presentation of subtotals?

The staff believe that entities that provide financing to customers as a main business activity shall not present the ‘profit before financing and income tax’ subtotal if the entity does not present expenses from financing activities or income from cash and cash equivalent below operating profit. This is because staff do not think it would be appropriate to give entities the option to present a misleading subtotal.

D. How do the proposals in this paper compare with the September 2018 staff proposals?

The outcome of the September 2018 proposals is in line with the proposal in the current paper. However, the September 2018 proposals give entities an option to either include income and expenses which are a part of their key performance metric in operating profit or present them below operating profit. Whereas the proposals in this paper require entities to include income and expenses which are a part of their key performance metric in operating profit and permit entities that provide financing to customers to include all their expenses from financing activities and income from cash and cash equivalent in the operating section (avoiding the need to allocate these expenses (income)).

E. Classification of expenses from financing activities for insurers

The staff think that insurers’ expenses on financial debt are not generally considered to be part of their key operating performance metric(s) because the insurance analysts consulted all expressed the view that insurer expense on financial debts should be presented outside operating profit because of a clear distinction between insurer’s operating activities and treasury/financing activities when compared to banks and insurer’s financial debt typically serves a different purposes than for banks (i.e. act as a buffer for regulatory capital purposes and not to generate net interest margin).

Therefore, the staff do not believe the Board should reconsider its tentative decision on this topic based on the feedback from user outreach.

Staff recommendations

In summary, the staff recommend that the Board reconsider its September 2018 tentative decisions as follows:

  • An entity that provides financing to customers as a main business activity is required to include in operating profit either:
    • Expenses from financing activities and income from cash and cash equivalents relating to its financing business activity
    • All expenses from financing activities and income from cash and cash equivalents
  • An entity that, in the course of its main business activities, invests in assets that generate a return individually and largely independently of other resources held by the entity is required to include in operating profit, income (expenses) from investments made in the course of its main business activities.
  • An entity that provides financing to customers as a main business activity shall not present the ‘profit before financing and income tax’ subtotal if the entity does not present expenses from financing activities or income from cash and cash equivalents below operating profit. This exception applies even when such an entity presents in the statement(s) of financial performance the unwinding of a discount on liabilities that do not arise from financing activities.

Board discussion

A majority of the Board members were in favour of the staff’s recommendations in Question 1 for the following reasons:

  • The proposals made include a self-policing mechanism as entities with significant financing activities would have an incentive to show expenses from financing activities and income from cash and cash equivalents from providing financing activities in operating profit.
  • Allowing this to be an accounting choice provides some relief when allocating between investing, financing and operating activities would not be possible on a reasonable basis or the cost of doing so would outweigh the benefits.

However, some Board members have expressed the following concerns:

  • By allowing the entity a choice, the comparability of the financial statements could be compromised. The Board suggested amending the proposal such that expenses from financing activities and income from cash and cash equivalents is to be classified in operating profit if a split cannot be made on a reasonable basis. However, other Board members questioned how to apply “reasonable” basis of allocation and that it might be interpreted as an internal measure or in terms of industry norms.
  • The term “main business activity” is too broad and subject to interpretation. The term could be interpreted as being dependent on the intent and designation by the entity or it could be a matter of fact. The staff clarified that there was an imprecision in the drafting of the agenda paper and confirmed that references to “main business activity” in the paper should be “main business activity from the provision of financing to its customers.”

The Board suggested the following amendments to the proposal:

  • To clarify in the Basis for Conclusions that the types of entities referred to in Question 1(b) of the staff proposal do not include entities which invest in excess liquidity generated as part of its main business activity; such as a car manufacturer which might invest cash generated from car sales. However, the scope does include entities such as a manufacturer with a significant financing arm or retail business with credit card facilities, which is a quasi-bank.
  • To state explicitly that, for an entity that provides financing to customers as a main business activity, recognising in operating profit all finance expense or allocating it on a reasonable basis is an accounting policy choice per IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. The Board also asked whether it would be possible to develop some guidance on how to allocate the expenses from financing activities and income from cash and cash equivalents in operating profit.
  • Public consultations may be required on whether the expenses from financing activities and income from cash and cash equivalents relating to its financing should be reclassified in whole or in part.
  • To clarify that it is not the Board’s intention to allocate items such as headquarter expenses but merely allocate the line items that are in financing or investing activities to operating activities.
  • To clarify that the income from investment in associates and joint ventures accounted for using the equity method is not included in the scope of this agenda paper but income from investments in associates and joint ventures accounted for at fair value is included.

Board decision

13 Board members voted in favour of the staff’s recommendation that an entity that provides financing to customers as a main business activity would be required to include in its operating profit either expenses from financing activities and income from cash and cash equivalents relating to its financing business activity or all expenses from financing activities and income from cash and cash equivalents.

All Board members voted in favour of the staff’s recommendation that an entity that invests in assets that generates a return individually and largely independently of other resources held by the entity in the ordinary course of its main business activity would be required to include income (expenses) from investments made in the course of its main business activities in operating profits.

All Board members voted in favour of the staff’s recommendation that the Board should not reconsider its tentative decisions on classification of expenses from financing activities for insurers.

Outstanding issues on the statement of cash flows (Agenda Paper 21B)

Background

This paper discusses two issues relating to the statement of cash flows. Whether to amend the tentative decisions on the starting point for the indirect reconciliation of operating cash flows and whether to remove options for classification of cash flows from interest and dividend for financial entities.

Staff analysis

The staff believe that the ‘operating profit’ subtotal is a more appropriate starting point than ‘operating profit and share of profit or loss integral associate and joint venture’ subtotal which was previously decided by the Board. This subtotal should be applied to all entities (financial and non-financial entities) because the reconciliation is straightforward without the need to adjust for share of profit from equity accounted investees. The reconciliation will be easier to understand and it will provide a link between operating profit and cash flows from operating activities.

The staff acknowledge that the location of the related income and expense in the statement(s) of financial performance would differ for financial entities and non-financial entities. Therefore, the staff have considered which of the Board decisions on classification of cash flows from interest and dividend can apply to all entities and what amendments to the Board’s decisions are needed for financial entities.

The staff have considered two possible approaches for financial entities:

  • Approach 1: ‘Aligned’ approach—to align the classification of interest and dividends in the statement of cash flows with the presentation of the related income or expenses in the statement(s) of financial performance. For example, the financial entities would allocate each type of cash in accordance with the location of related income and expenses in the statement(s) of financial performance, in investing, operating or financing activities.
  • Approach 2: ‘Single’ approach—to require each type of interest and dividend cash flow to be presented in a single section of the statement of cash flows. For example, financial entities would classify each type of cash flow in a single section of the statement of cash flows, even if the related income and expenses are in multiple sections in the statement(s) of financial performance. The staff considered two variants of Approach 2: Entities could either present each type of cash flows based on which section in the statement(s) of financial performance the most related income/expense is included. Alternatively, if the entity presents related income/expense in a single section of the statement(s) of financial performance, the entity shall present related cash flows in that section and if the entity presents related income/expense in more than one section of the statement(s) of financial position, the entity has an accounting policy choice to decide in which section of the statement of cash flows it presents the related cash flows. Both variants results in an alignment between the statement of cash flows and statement(s) of financial performance but the latter variant is preferable to staff.

Staff recommendations

Overall, the staff recommend the following:

  • Starting point for the indirect reconciliation of operating cash flows should be the operating profit subtotal, for all entities
  • All entities shall classify cash flows from dividends paid as financing cash flows and cash flows from dividends received from equity-accounted associates and joint ventures as investing cash flows.
  • Entities that provide financing to customers as a main business activity and/or invest in the course of their main business activity in assets that generate a return individually and largely independently of other resources held by the entity, shall classify each of cash flows from dividends received, interest paid and interest received in a single section of the statement of cash flows; and such entities shall determine the section in which to classify each of cash flows as follows:
    • if the entity presents the related income/expenses in a single section of the statement(s) of financial performance, the entity shall present related cash flows in that section; or
    • if the entity presents related income/expenses in more than one section of the statement(s) of financial performance, the entity shall make an accounting policy choice regarding the section of the statement of cash flows in which to present related cash flows.

Board discussion

Some Board members expressed concerns about the staff’s recommendation to give preparers of financial statements of a financial entity an option to either present related income/expense in a single section or multiple sections of the statement of cash flows because:

  • If an entity were to present income/expense from related activities in a single section on the statement of cash flows, this would reduce the alignment between the statement(s) of financial performance and the statement of cash flows. As the Board tentatively decided to use operating profit as a starting point for the statement of cash flows, by adopting the staff’s recommendation, it may result in a further disconnect between the statement of cash flows and the statement(s) of financial performance and reduce the comparability and consistency between the two statements. Further to this, some Board members believe that they should not forbid the entity to align the two statements. However, the staff noted that this is not possible under the current recommendation.
  • This is not a self-policing recommendation.

However, many Board members agreed that there are advantages to the staff’s recommendations for the following reasons:

  • The users of the financial statements have two separate needs from the statement of cash flows and the statement(s) of financial performance and therefore misalignment arising from the choice to present related income/expense in a single section may not be detrimental for the users of the financial statements. However, the Board believes that this should be explained further in the Basis for Conclusions as to why there is an apparent disconnect between the statement(s) of financial performance and the statement of cash flows.
  • Some entities may have many types of activities that may not be classified into a single category. Therefore, by allowing this as an accounting policy choice, the entity may choose to present related income/expense in a single or multiple locations depending on their business.

Board decision

All Board members voted in favour of the staff’s recommendation that operating profit should be required as the starting point for the indirect reconciliation of cash flows and this requirement should apply to all entities.

All Board members agreed with the staff’s recommendation that all entities should classify cash flows from dividends paid as financing cash flows and cash flows from dividends received from equity-accounted associates and joint ventures as investing cash flows.

11 Board members agreed with the staff’s recommendation that entities that provide financing to customers as a main business activity and/or invest in the course of their main business activity in assets that generate return largely independently of other resources held by the entity should classify each of the cash flows from dividends received, interest paid and interest received in a single section of the statement of cash flows and such entities shall determine the section in which to classify each of cash flows as follows:

  • If the entity presents the related income/expenses in a single section of the statement(s) of financial performance, the entity shall present related cash flows in that section
  • If the entity presents related income/expenses in more than one section of the statement(s) of financial performance, the entity shall make an accounting policy choice regarding the section of the statement of cash flows in which to present related cash flows

Additional proposals on aggregation and disaggregation (Agenda Paper 21C)

Background

This paper develops the guidance supporting aggregation and disaggregation of line items in the primary financial statements and in the notes.

Staff analysis

The staff believe that the Board should replace the guidance tentatively decided by the Board on the steps involved in the financial statement preparation with a description of the aggregation and disaggregation principles and supporting guidance to the principles, definitions and guidance around preparation of primary financial statements. This is because providing guidance rather than prescribing steps would give better context to the reasoning behind these principles.

The staff further suggest that the Board could provide additional guidance for material balances comprised of immaterial items (i.e. when immaterial items of dissimilar characteristics is labelled as ‘other’ in the financial statements) as these do no faithfully represent the items, especially without additional information.

The Board has tentatively decided to describe principles of aggregation and disaggregation, defining aggregation, disaggregation and classification to provide a common terminology, and describing the steps involved in the preparation of the primary financial statements and the notes. However, the staff highlighted that the guidance should consider the role of materiality in aggregation and disaggregation decisions and should distinguish between presentation in the primary financial statements and disclosure in the notes.

Staff recommendations

In summary, the staff recommend the following:

  • The Board should replace the guidance tentatively decided by the Board on the steps involved in the preparation of financial statement which involve:
    • Classifying individual transactions or other events into assets, liabilities, equity, income and expenses
    • Separating assets, liabilities, equity, income and expenses into groups based on their characteristics (for example, their nature, their function, their measurement basis or another characteristic) resulting in the presentation of line items that share at least one characteristic in the primary financial statements
    • Separating the line items presented in the primary financial statements based on further characteristics resulting in the separate disclosure of items in the notes, provided they are material
  • The Board should provide supporting guidance on the aggregation of line items on the primary financial statement and disaggregation of line items disclosed in the notes to the primary financial statement if the line item is material
  • The Board should provide additional guidance for material balances comprised of immaterial items and what would be faithful representation of such line items. For example, in order to faithfully represent these items, an entity shall:
    • Reconsider whether the immaterial item(s) share similar characteristics with other item(s) and can be aggregated to create a material item that can be described in a manner that faithfully represents the aggregated items
    • Consider whether the aggregated items may be described in a way that faithfully represents the dissimilar items without changing the level of aggregation
    • If the above are impractical, disclose information in the notes about the composition of the aggregated item, for example, ‘the balance consists of several unrelated immaterial amounts, the largest balance of which is CU10 of onerous lease expenses’

Board discussion

The Board suggested that the steps as recommended by the staff could become the guidance statements. However, the staff clarified that these steps as recommended in the paper were intended to replace the steps in the previous tentative decisions made by the Board in March 2017. The Board raised concerns over the following:

  • Whether the starting point of disaggregation should be the face of the primary financial statements or whether it should be the disaggregated note line items, which is then reconciled and aggregated into the line items on the primary financial statements. Some information provided in the notes might not reconcile back to the face of the primary financial statements. The staff clarified that the purpose of the recommendation is to require the preparers to consider which items may require further disaggregation and is open to judgement and materiality. The staff further clarified that the aim of this paper is to discuss the disaggregation of financial information and do not relate to supplementary information which would need to be provided if material.
  • Whether disaggregation occurs at the transaction level or at the event level and whether the disaggregation principle applies to the notes to the financial statements or the financial statements in their entirety. For example, when might an entity disaggregate receivables balances into trade receivable and other receivable? Or when might an entity further disaggregate other receivables into more detailed line items? Further disaggregation may be difficult in practice and where do the preparers draw the line to further disaggregation? The staff confirmed that the disaggregation principle should be applied to the financial statements as a whole. This is because industry expressed a view that for the notes to the financial statement to provide more useful information they need to be disaggregated further.
  • Which line items can be aggregated and when might an entity disaggregate should be clarified. For example, some insurance balances which are assets and liabilities may be permitted to be presented as a single line item. However, the staff reminded the Board that these are exemptions to the general principle and this relates to the principle of offsetting in IAS 1 Presentation of Financial Statements rather than the principles described in this paper and the staff suggested that this can be clarified in the Basis for Conclusions.

Board decision

13 Board members voted in favour of the staff’s recommendation to replace the guidance tentatively decided by the Board on the steps involved in the preparation of financial statements.

All Board members voted in favour of the staff’s recommendation to provide supporting guidance on the aggregation of line items on the primary financial statements and disaggregation of line items disclosed in the notes to the primary financial statements if the line item is material.

13 Board members agree with the staff’s recommendation to provide additional guidance for material balances comprised of immaterial items and what would be faithful representation of such line items.

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