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Primary financial statements: a game changer in reporting?

International Accounting Standards Board chair Hans Hoogervorst delivered a speech at the Seminario International sobre NIIF y NIF, organised by the Consejo Mexicano de Normas de Información Financiera in Mexico. The Accountant presents the highlights.

Most of you will be familiar with the IFRS story. Since 2001, an ever-increasing number of jurisdictions have adopted our standards.

In 2005, the EU led a first wave of jurisdictions adopting IFRS Standards. That was closely followed by a second wave of adopters, including the large Latin American jurisdictions such as Mexico and Brazil.

Today, of 166 jurisdictions researched by the IFRS Foundation, 144 – roughly nine out of 10 jurisdictions – have adopted IFRS Standards. That includes 15 of the G20 major economies.

That is a remarkable achievement in such a short period of time. Here in Latin America, jurisdictions representing more than 99% of regional GDP have now adopted IFRS Standards.

Moreover, we continue to see continued progress in other parts of the world. Jurisdictions such as China, India and Indonesia have achieved substantial convergence between their national accounting requirements and IFRS Standards, although some differences remain. China especially is now very close: many of its big companies show identical results under IFRS and Chinese GAAP.

In Japan, companies have had the option to adopt IFRS since 2012. After a relatively slow start, we are now seeing many of the major Japanese companies adopting or planning to adopt IFRS. To date, almost 200 companies representing more than 30% of the total market capitalisation are using IFRS Standards. Only last month, the CFO of Toyota – Japan’s largest company – stated his intention to adopt IFRS Standards in the near future.

That leaves the US as the only large jurisdiction where adoption has stalled. But even there, IFRS plays an important role. More than 500 foreign companies listed in the US report using IFRS Standards, with a total market capitalisation of more than $7trn, while US investors have more than $4trn of mutual funds invested outside the US, much of that in IFRS jurisdictions.

In summary, although the map of the world is not yet complete, IFRS has now become the de-facto global language of financial reporting.

Projects and Initiatives
Currently, the board is focusing more on how financial information is presented. We call this our Better Communication initiative. One of the most important parts of Better Communication is the Primary Financial Statements project.

The objective of the Primary Financial Statements project is to provide better formatting and structure in IFRS financial statements, especially in the income statement. Currently, the IFRS income statement is relatively form-free. We define revenue and profit or loss, but not all that much in between.

In practice, both preparers and investors like to use subtotals to better explain and understand performance. Our lack of guidance in this respect has had the unintended consequence of stimulating the use of self-defined subtotals, also known as non-GAAP measures. Non-GAAP measures can be useful to explain different aspects of the performance of a company and we do not intend to root them out.

However, non-GAAP measures are often non-comparable. Subtotals like operating profit and EBITDA are very commonly used, but in practice companies define these subtotals in very different ways.

Moreover, many non-GAAP measures tend to paint a very rosy picture of a company’s performance, almost always showing a result that is better than the official IFRS numbers. This is the second reason why we decided it was important the IFRS Standards themselves provide more detail and structure.

Providing more structure to the financial statements is also important, as more financial information is produced and consumed digitally. There is more and more automated investing going on, and increasingly artificial intelligence is used to help investors digest information from vast numbers of financial statements. The greater the amount of data consumed by investors and the greater the reliance on technology, the more important it is that data is properly structured, consistently defined and tagged.

The first subtotal we have looked at is operating profit. This is the most commonly used subtotal around the world, and it currently lacks an IFRS definition. We have decided to define operating profit as profit excluding financing, tax and income/expenses from investments. We are convinced that our definition of operating profit shows what most would view as the results of a company’s main business activities.

The IASB understands that the definition of operating profit as profit excluding financing, tax and income/expenses from investments does not work for financial entities, such as banks. For a bank, clearly providing loans to customers is a main business activity, so excluding all financing expenses from operating profit makes no sense.

For this reason, the IASB has decided to require financial entities to include expenses from financing activities relating to the provision of financing to customers in operating profit. We have found similar solutions for insurers and investment companies.

In practice, many companies may have a slightly different view on what they consider their operating profit and they may be tempted to present an adjusted non-GAAP measure of operating profit.

However, the advantage of having an IFRS-defined subtotal of operating profit is twofold. First, investors will have at least a common denominator of operating profit that is comparable across companies and industries. Secondly, if companies want to present an adjusted measure of operating profit, the official IFRS definition will serve as an additional anchor in the income statement to which the adjusted number can be reconciled. This way, adjustments to operating profit will become much more transparent, leading to better comparability.

Below operating profit, we have created what can loosely be called an investment category. This category includes income and expenses from investments, from financial investments to associates and joint ventures. Investors tend to look at such investments separately from operating profit.

A second important subtotal that the IASB has decided to define is what we call profit before financing and tax. As the name indicates, this subtotal excludes expenses from financing activities – such as interest expense on loans or bonds – and tax.

Users often want to compare companies’ performance before the effects of financing and this subtotal enables that comparison. In other words, the profit before financing and tax subtotal enables comparison of companies with different capital structures. It creates better comparability of the performance of companies independent of their degree of leverage.

The board has looked seriously at the possibility of us trying to define and own the very commonly used non-GAAP measures of EBIT and EBITDA. The problem with the terms EBIT and EBITDA is that they have evolved gradually over time, without clear underlying concepts. The acronyms are used very loosely and their components often differ significantly from their literal meaning.

The lack of conceptual clarity and precision makes the use of these subtotals very problematical. Apart from that, there are many people who have serious qualms about the information value of a subtotal like EBITDA.

Moreover, over time, preparers and users might start using the subtotals that we have defined – operating income and profit before finance and tax – as building blocks for their own analyses.

They might find our definitions workable for their own subtotals, whether EBIT or EBITDA or others, and they might wish to reduce the need for reconciliation. Over time, some spontaneous convergence between non-GAAP and GAAP might take place.

In addition to improving the structure of the income statement, we have developed guidance that will improve disaggregation. Currently, all too often, many components of the income statement are lumped together in other income or expenses. For many investors this is a big source of frustration, and our guidance will make excessive aggregation much more difficult.

Finally, we will require companies to disclose in the notes which components of income or expense they judge to be unusual, either in size or in frequency.

Adjustments for unusual items are now very commonly done in the realm of non-GAAP. Clearly, this is important information for investors in their efforts to predict future cash flows. Yet, it is also one of the areas of non-GAAP where a lot of cherry-picking is going on.

Unsurprisingly, companies tend to focus on what they see as unusual expenditures rather than on identifying windfall profits. While it will never be perfectly possible to identify unusual items, we aim to develop principles that will strengthen discipline in this area.

Overall, our decisions thus far will create much more structure in the income statement, and will definitely enhance comparability. The improved structure will make it much easier for users to find the components for the analysis that they prefer.

The increased transparency around the adjustments that companies make in their non-GAAP measures will provide the investor with a lot of information about the underlying strategy of management. Do these adjustments reflect a credible strategy for long-term value creation, or do they seem inspired by a wish to embellish results?

Our work is not done yet, and we still have some tough nuts to crack. I am optimistic, though, that our work on the primary financial statements can become a real game changer in reporting. 

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