Relevance – Relevant financial information is capable of making a difference in decisions made by users if it has predictive value, confirmatory value or both.
Predictive value – the financial information is useful because it can be used as an input to processes employed by users to predict future outcomes, in making users’ own predictions.
Confirmatory value – the financial information is useful if it provides feedback about previous evaluations (confirms or changes a previous understanding).
The principle that financial reporting measurements should provide relevant information seems to be indisputable. Two points are worth noting.
- Relevance is subjective. What is relevant to one user of information is not necessarily relevant to another. Even groups of users that are often referred to as though they have identical interests, such as shareholders, are likely in practice to have diverse preferences as to what they regard as relevant
- Relevance frequently conflicts in practice with the achievement of other objectives, such as accuracy and reliability. For example, current values may be more relevant than historical costs, but may be less reliable. Forecasts of future cash flows may be even more relevant and even less reliable. Behavioural factors also tend to make information less reliable the more relevant it is.
IAS 8 14(b) An entity shall change an accounting policy only if the change results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows.
Any measurement based on estimates is inherently imprecise, whether that measurement portrays the sum of cash flows or their present value. Estimates of the future usually turn out to have been incorrect to some extent, and actual cash flows often differ from estimates. However, neither relevance nor reliability is the paramount characteristic of accounting information. The two must be balanced against one another, and the weight given to each will vary from one situation to the next.
However, a simple choice between present value and undiscounted measurement often presents a false dilemma. Techniques like the use of expected cash flows can extend the application of present value to measurements for which it was previously considered unsuitable. The use of simplifying assumptions allows accountants to develop present value measurements that are sufficiently reliable and certainly more relevant than undiscounted measurements.
Primary financial statements
The objective of the Primary Financial Statements project is to provide better structure and content in IFRS financial statements, especially in the income statement. Currently, the IFRS income statement is relatively form-free. We define Revenue, we define 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.
These measures can be useful to explain different aspects of the performance of a company and we do not intend to root them out. However, their use should come with a ‘health warning’—or maybe a ‘wealth warning’ is a better way to describe them.
Subtotals like Operating Profit and EBITDA are very commonly used, but in practice companies define these subtotals in very different ways. How many investors actually know about these differences? Some will, but I am sure that most investors are left profoundly confused.
Our technical staff looked at 60 companies in different countries and industry sectors. About 70% of those companies used an Operating Profit subtotal, but there were no fewer than nine different versions of that subtotal—even though each subtotal used the same name. Some included investment incomes, others did not. Some included profits from joint ventures, others did not. And some excluded various items they consider non-operating or non-recurring. This is what financial reporting looks like in the absence of standards.
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. An interesting study in the US a few years back showed that around 9 out of 10 companies in the S&P 500 disclose non-GAAP metrics and 8 out of 10 showed increased net income. The ‘core earnings’ metric was on average 30% higher than GAAP earnings. While these are numbers for the American market, we see similar challenges in IFRS markets.
IASB Improvement project
First, we will improve comparability by defining some of the commonly used subtotals as IFRS numbers. Second, where management still feel the need to provide additional metrics, we will require increased transparency and discipline around the calculation and presentation of those subtotals.
The first, and most important, subtotal for the income statement we have defined is Operating Profit.
Operating Profit is the most commonly used subtotal around the world, yet it is not defined in IFRS Standards. We have defined Operating Profit as profit excluding financing, tax and income and expenses from investments. Many investors we spoke to viewed this as a reasonable measure of a company’s main business activities.
The Board understands that this definition of Operating Profit does not work for financial entities, such as banks. For this reason, we have 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.
A second important subtotal that the Board 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.
Management performance measures
In addition to these new subtotals, the Primary Financial Statements (PFS) project will introduce greater transparency and discipline to the use of subtotals not defined in IFRS Standards. Traditionally known as non-GAAP, we have decided to call such subtotals ‘Management Performance Measures’, or MPMs. This definition makes it clear that these are performance measures created by the management of a company.
We aim to improve transparency around management performance measures by requiring companies to locate MPMs and the information explaining these measures within a single note in the financial statements. This will make it much easier for investors to find the information. Currently, they often need to search around for this information both in and outside the annual report.
Some may worry that bringing MPMs into the financial statements enhances the status of non-GAAP. However, the presentation of the MPM’s will be subject to much of the discipline that many market regulators around the world already require. Management will need to explain how the MPM is calculated and why it is important. Consistent recognition and reporting will be required from one period to another, and if a company decides to change its performance measures, it will have to explain why.
Discipline also comes from requiring companies to provide a reconciliation between their own performance measures and the closest IFRS-defined subtotal. This will help investors to better understand how the company arrived at a particular number, and perhaps more interestingly, why management apparently thinks that an IFRS subtotal was insufficiently clear about the company’s performance.
Moreover, by bringing the MPMs into the notes, they will have to be in line with the ‘fair presentation’ requirements set out in IAS 1. This should help weed out MPMs that are clearly unbalanced. The MPMs will also be brought into the scope of audit, something which will further strengthen discipline. While we recognise that MPMs are here to stay, we see our role as helping investors in their analysis by shining a brighter light on them. Relevance
Disaggregation and unusual items
We have also developed guidance that will improve disaggregation. Many components of the income statement are lumped together in ‘other income or expenses’. We have seen cases where this item comprises more than 50% of total expenses! For many investors this is a big source of frustration. Our improved guidance in this respect will make excessive aggregation much more difficult. Relevance
In addition, companies will be required to disclose in the notes any items of income or expenses that are ‘unusual’, either by size and/or frequency. Clearly, this is important information for investors in their efforts to predict future cash flows. Relevance
Adjustments for unusual items are common in the realm of non-GAAP. 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 expenses rather than unusual income. This is one of the main reasons self-defined measures often show better performance results than the IFRS numbers. Investors would certainly benefit from greater symmetry between unusual expenses and unusual income. Relevance
While it is difficult to define unusual items perfectly, we will provide guidance as to how to do so. We will stipulate that items can only be categorised as unusual if they have limited predictive value—i.e. it should be reasonable to expect that the same item will not appear again for several years. Relevance
See also: Conceptual Framework 2018
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