Conflict between management and external user needs

The following article was originally published by Wiley Insight IFRS.

Conflict is inherent between management’s use of historical financial statements for interpreting and explaining the financial position and performance of an entity and investors’ use which includes comparability between entities.

The ultimate decision to be made is in answer to the question: Should management be permitted to incorporate their discussion and analysis into the general purpose financial statements prepared in accordance with IFRS?

In raising this question, the IASB staff are blurring the distinction between non-GAAP and additional GAAP measures which may also make global regulatory differences more apparent.

A note on terminology and source

The IASB has adopted the terminology of Alternative Performance Measures (APMs) and describes those measures as “competing with” IFRS measures, and as typically receiving more emphasis than the IFRS measures. The equivalent term, non-GAAP measures, is used in this article, and also by the Canadian regulator.

IAS 1 distinguishes between information that is specifically required to be included in financial statements because it is necessary for an understanding of financial position or performance (additional GAAP measures), and any other information that is not required for an understanding or non-GAAP.

The agenda papers in which the staff discuss these and related issues can be found at the end of the article.

Inclusion of non-GAAP information in financial statements

The staff papers contemplate allowing the inclusion of non-GAAP information in general purpose financial statements prepared in accordance with IFRS. Examples include sales per square metre, churn rates and capital expenditure.

IASB staff do appear to be addressing investor needs:

“placing some types of information together, such as management’s plans and strategy together with actual results, can help an entity to tell an integrated story about its financial position and financial performance.”

The Canadian regulators specifically disallow a reporting issuer from including non-GAAP measures in financial statements. Therefore, the change would go well beyond the Canadian rules and be a fundamental shift in international financial reporting.

The change would also bring financial statements more into line with – and indeed, competing with – management’s discussion and analysis (MD&A) which is intended to be written from management’s perspective, “through the eyes of management.”

Issues arising

Under current rules, entities must determine which information is above and beyond what is actually required by IFRS to make the financial position and performance understandable. That is a judgment call. If non-GAAP information is permitted, or required, to be included in financial statements then the difference between GAAP measures and non-GAAP measures becomes academic.

Gross profit and operating profit

It seems clear that presenting non-GAAP information in financial statements would make such differences apparent. For example, the staff provide examples such as gross profit and operating profit as non-IFRS. Global differences in what are considered non-GAAP as opposed to additional GAAP measures already exist. In some jurisdictions those sub-totals would be considered non-GAAP measures by regulators. To avoid regional versions of financial reporting any disclosure standard would have to provide detailed guidance and examples.

Presentation and prominence of non IFRS metrics

Other concerns include that the additional information would draw attention away from the IFRS information, or that it may be “given undue prominence or credibility merely because of its location.” Ultimately, the staff paper concludes that the benefits of bringing MD&A-type discussion and metrics into the financial statements would provide better information for users and would outweigh the concerns.

Audit costs and requirements

The IASB staff consider including such MD&A type discussion and information in the financial statements, but excluding certain information from the audit requirement. This gives rise to a concern about being able to “identify a complete set of financial statements, including, in a set of audited financial statements, whether the information is audited or not.”

Annual financial statements of reporting issuers are subject to audit. The paper points out that audit cost and the sensitivity of disclosing information to competitors would act to control the volume of such information included in financial statements.

What is required to make this happen

The IASB staff considers that the primary financial statements act as a high altitude overview of the financial position and performance of an entity and allow a user of the financial statements to go into more detail in certain areas of interest. In addition, the consistency of presentation also allows a comparison of financial position and performance between different entities.

The information included in the primary statements has a “summary and signposting role” which may be given “undue prominence” by management and “hence receive excessive attention” by users. Therefore the IASB staff recommend that a new disclosure standard would be necessary.

The IASB has approved narrow focus amendments to IAS 1 which are effective for annual periods commencing on or after 1 January 2016 with earlier adoption permitted. Those amendments provide standards that need to me met for an entity to include additional subtotals on the face of the statement of financial position and comprehensive income. The broader discussion over non-GAAP measures continues.

Criteria for inclusion

In serving the needs of the investor community and making historical financial statements more relevant and useful, the IASB is looking to identify the criteria that would need to be in place to allow non-GAAP information to be included in the financial statements or in the notes. Possible criteria suggested by the IASB staff could include:

“(a) be reconciled (where possible) to the most directly comparable measure defined or specified in IFRS and presented in the statement of financial position or performance;

(b) explain why the APM provides relevant information about an entity’s financial position or performance and why the adjustments to the most directly comparable measure …have been made;

(c) be presented and labelled in a manner that makes it clear and understandable what the APMs show and how they are constructed;

(d) provide comparatives and be clear and consistent…from period to period and explain if adjustments have been made…;

(e) not be displayed with more prominence than the subtotals and totals required in IFRS for that statement; and

(f) be clear whether the APM forms part of the financial statements and whether it is audited…on the same basis as the IFRS information.”

Similarly, guidance could also be put in place regarding the presentation or disclosure of items that are non-recurring or that only occur infrequently. And that guidance would include definitions of those terms which are currently not provided in IFRS.

In conclusion

The staff paper concedes that investors find additional measures useful in analysing financial position and performance. At the extreme the IASB staff note that “even APMs that are viewed as being biased can provide information that is useful in assessing management’s character.”

The needs of investors are driving the IASB staff argument for including such information in financial statements, and the IASB is looking to expand the IFRS framework to not only allow, but to encourage, their use within the confines of new reporting rules.

Such a shift in the IFRS financial reporting framework would require the Canadian regulators to change their position to allow non-GAAP measures in the financial statements of reporting issuers.

In the Canadian market the regulators have consistently raised concerns over the biased way in which certain entities have reported results outside of the audited financial statements. It seems clear that requiring an audit opinion to cover all the information included in the financial statements would act as a control over the quality of that information in addition to acting to limit the volume of such content.

Related material

IASB staff papers (February 2015): Disclosure Initiative: Principles of Disclosure

IASB staff paper on the Performance Reporting project (Global Preparers Forum Meeting) March 2015

Mind the Gap (Between non-GAAP and GAAP) – Speech by Hans Hoogervorst

Korean Accounting Review International Symposium, Seoul, Korea, 31 March 2015

Identifying the amount of an entity’s liabilities that should be classified as current

The following scenarios and questions were initially published by Wiley Insight IFRS

Scenario One

At the reporting date, Entity A enters into an interest only loan of CU1 million repayable in ten years’ time with interest of CU 100,000 payable annually. Under IFRS, the loan would be recorded at the reporting date at CU1 million (ignoring transaction costs). Assume that the present value at the reporting date of the CU 100,000 interest payable at the end of the reporting period is CU 92,500.

Scenario Two

At the reporting date, Entity B borrows CU5 billion over 30 years. Payments of CU600 million, comprising principal and interest are due at the end of each year. Under IFRS, the loan would be recorded at the reporting date at CU5 billion (ignoring transaction costs). At the end of the first year, the principal component of the payment of CU600 million is CU60 million. Assume that the present value at the reporting date of the CU600 million payable at the end of the reporting period is CU550 million and the present value at the reporting date of the principal component of the payment is CU55 million.

  1. In Scenario One, what portion, if any, of the CU1 million should Entity A classify as a current liability at the reporting date?
  1. For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Debt that is accounted for at amortised cost requires that the interest cost of the debt be allocated to periods using the effective interest rate, which is the rate that exactly discounts estimated future cash payments through the life of the financial instrument to the net carrying amount of the liability. Therefore at any time, the current carrying amount of the liability is equal to the present value of all future cash payments. To consider this from the opposite direction of time, the principal amount of the debt compounds at the effective interest rate during the life of the instrument.

On each anniversary date when the interest is paid, the present value of all future cash flows will be CU1 million. In the example, since the interest is only paid annually, this relationship will not hold true – assume interest for the year is paid on December 31. Between January 1 and December 30 of the following calendar year the future cash outflows remain the same in nominal dollars, however, the time period over which they are discounted changes (the time period decreases as the year progresses).

Therefore the effect of the discount becomes less, and the carrying amount of the liability increases. This increase in the liability is the interest cost which is accrued but not yet paid. This change in the carrying amount of the liability only occurs because the interest is paid annually (this effect would disappear if interest was paid daily). At all times the CU1 million loan will be presented as long term, and the difference between the CU1 million and the present value of the instrument, namely the accrued interest, will be shown as current.

The amount of the accrued interest will not be the same as the present value of the next interest payment. Instead, the carrying amount of the debt at the reporting date will be the present value of all future cash flows. Individual cash flows are not discounted. This can be seen in the response below to Scenario Two.

  1. In Scenario Two, what portion, if any, of the CU5 billion should Entity B classify as a current liability at the reporting date?
  2. For both scenarios can you identify, based on your experience, the amount that reporting entities would typically classify as current?

Assuming the calculation as presented in the scenario is correct, the CU60 million portion of the combined principle and interest payment should be presented as the current component of the debt. The present value of this amount is not relevant to the current versus long term classification question. Recall the effective interest method described above: the total of the cash flows are discounted to determine the carrying amount of the debt. Therefore the CU5 billion on initial recognition is the discounted amount of those total cash flows. The CU60 million principle component is a portion of that principle balance, that is, it is discounted already. If it was discounted again to determine the classification, then we would be doubly discounting the amount.

By constructing an amortization table for the loan it can proved that the effective interest rate is approximately 11.547776%. I am clarifying the scenario by assuming the loan is entered into on the last day of one reporting period and the first repayment is made on the last day of the following reporting period (year 1 in the table following).



initial loan interest repayment closing


1 5,000,000,000 577,388,800 (600,000,000) 4,977,388,800
2 4,977,388,800 574,777,709 (600,000,000) 4,952,166,509
3 4,952,166,509 571,865,096 (600,000,000) 4,924,031,605
28 1,452,373,314 167,716,817 (600,000,000) 1,020,090,131
29 1,020,090,131 117,797,723 (600,000,000) 537,887,854
30 537,887,854 62,114,085 (600,000,000) 1,939

The table illustrates the effective interest method: interest calculated at this effective rate on the opening balance each period with combined principle and interest payments of CU600 million at the end of each year leaves a zero balance after 30 years.

From the table the closing principle balance at the end of the first year, after making the first repayment, is CU4,977 million. Therefore of the CU5 billion initial debt, CU23 million is due within one year and is presented as current, and the remaining CU4,977 million is presented as long term. The principle and interest components of the CU600 million payments are not individually discounted.

  1. For both scenarios state the amount you believe should be classified as current in accordance with the requirements of the standard. Please provide a rationale for your view.

The current balances for each of these instruments have previously been referred to.

From my experience, reporting entities in the Canadian jurisdiction would also take the approach described above in measuring current liabilities. The rationale, which I agree with, is based on the principle stated in the preamble, and that principle represents the definition of the amortised cost of a financial liability. The definition from IAS 39 paragraph 9 reads, “The amortised cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principle repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between the initial amount and the maturity amount…”

Applying this calculation method to the future cash flows for Scenario Two is a proof (effectively performing the calculation in reverse) of the amortization table presented above. Performing the calculation at the opening and closing dates for any year proves the amounts presented in the table. Logically, the difference between those two amounts is the amount of principle repaid during the period which should therefore be presented as current on the statement of financial position.

Impairment losses of financial instruments, current and future

Consider a financial instrument asset accounted for at amortized cost in accordance with IAS 39. The allowance rules under IAS 39 mean:

  • No loss is allowed to be recognized when a financial instrument is initially recorded; and
  • After initial recognition, a loss is allowed only if (i) there is objective evidence of impairment; and (ii) that evidence has to be due to a past event (that is, after the asset was recognized and before the balance sheet date).

Therefore, losses as a result of future events, even events that have already occurred in the period subsequent to the report date, are not allowed to be included in the provision.

An impairment loss under IFRS is calculated as the difference between the present value of the future cash flows expected from the asset (discounted at the effective interest rate) and its carrying amount at the report date.

The above criteria for recognizing an impairment loss under Accounting Standards for Private Enterprises (ASPE) is consistent, in that an entity must only consider “whether a significant adverse change has occurred during the period in the expected timing or amount of future cash flows.”

When the new IFRS 9 is adopted, which is for years commencing after January 1, 2018 at the latest, the loss provision will look quite different and the new standard will mean a significant divergence in IFRS from ASPE.

Without getting bogged-down in the details, under IFRS 9:

  • An impairment allowance is recognized for all financial instrument assets, and not just after their initial recognition. For an asset recognized on the last day of the reporting period, an impairment allowance is also required to be set up.
  • The impairment loss calculated is based on the credit risk, or more accurately changes in credit risk, since the asset was initially recognized:
    • If the credit risk has not increased significantly since the asset was recognized, then the allowance set up is equal to the 12-month expected credit loss.
    • If the credit risk has increased significantly, then the allowance is equal to the lifetime expected credit loss.
  • The assessment of changes in credit risk between initial recognition and the report date is based on the change in the risk of default occurring over the expected life of the asset, and that assessment must consider:
    • reasonable and supportable information;
    • including forward looking information;
    • that is available without undue cost or effort; and
    • that is indicative of significant increases in credit risk.
  • If reasonable and supportable information is available, an entity cannot rely solely on past-due information.
  • There is a rebuttable presumption that risk has increased significantly when contractual payments are more than 30 days past due.

Our observations of the new impairment rules are:

  • Recognition of impairments under the new rules are aligned with the business model and the pricing of risk.
  • The new test is future looking, which is explicitly disallowed under the current rules.
  • Furthermore, the impairment must be based on ‘evidence,’ so there has to be some fact or information that proves or corroborates the impairment – management cannot hide behind an estimate.
  • In looking for indicative information entities are required to look for data that is correlated with historical losses and to use that information in IFRS 9 loss allowances. For example, if there is an upswing in unemployment rates in advance of increased credit losses historically, then forecasts of future unemployment could be identified as the relevant forward looking information on which to base impairment losses under IFRS 9.

When entities are adopting the new rules in a downward economic cycle impairment losses could be expected to increase. Clearly, however, this depends on what factors an entity identifies as being correlated with its historic losses.

Application of Events after the Reporting Period (IAS 10)

The basis for recognizing adjustments to the financial statements for events occurring after the reporting period and before the financial statements are authorized for issue (subsequent events) is that the event must provide evidence of conditions that existed at the reporting date.

A going concern exception must be applied, such that the going concern basis is not used if events after the reporting period lead to a conclusion that the entity is not a going concern, even if that condition did not exist at the report date.

If an event provides evidence of a condition arising after the reporting date, consideration should be given to whether it is material and requires disclosure. In some cases the distinction is clear, for example the destruction of plant by fire.

Guidance is provided, in the context of subsequent events, for the following examples in the respective standard:

  • Closing a business combination – the criterion for whether a subsidiary is accounted for in the period or in the subsequent period is the date that the acquirer obtains control. In most cases, the date that control is acquired is the same as the closing date for legal purposes, however, it could be earlier or later than the legal closing date depending on the facts and circumstances.
  • Announcing a plan to discontinue an operation and classifying a non-current asset as available for sale – the condition that must exist at the reporting date includes the commitment of senior management to the plan to sell.
  • Announcing a restructuring – to recognize a provision for the restructuring at the reporting date a ‘present obligation’ has to exist at that date as a result of a past event. A present obligation requires that the entity has no realistic alternative but to settle the obligation. Therefore, the obligation may be enforceable by law or by a constructive obligation (meaning that other parties have a valid expectation that the obligation will be settled).
  • Recognizing tax liabilities and assets – the tax rates to be used in measuring tax balances are those that are enacted or substantively enacted by the end of the reporting period. The exact date that rates become substantively enacted depends on the legislative process which can therefore vary between jurisdictions.

Dealing with other events requires application of the principle to the facts and circumstances of the case, and the term ‘conditions at the balance sheet date’ is strictly applied under IFRS. Consider an entity that has debt outstanding that has become payable on demand due to the breach of a financial covenant at the report date.

Prior to the financial statements being issued, the lender will often provide a waiver of the breach. However, because the breach existed at the balance sheet date, the debt should still be classified as current on the statement of financial position. The fact that the lender has waived its rights after the reporting date would be disclosed but does not affect the classification of the debt.

Under Canada’s Accounting Standards for Private Enterprises (ASPE) the debt would be classified as long term in this same scenario. This point is therefore a significant difference between the two frameworks and is often overlooked by preparers of financial statements under IFRS.