The IASB’s Financial Statement Presentation project and its potential effects on financial ratio analysis

2.1 Core Principles of the Financial Statement Presentation

According to SD-FSP. 44 the presentation of information in the financial statements shall consider both, the disaggregation principle and the cohesiveness principle. Due to the first-mentioned principle information shall be presented in a manner that explains the activities in which an entity is engaged, and furthermore explains its financial position, its performance and its cash flows. Unless the items in the financial statements are immaterial, functions, natures and measurement bases are used as separation criteria in order to classify items in different classes.5 The disaggregation of items by functions refers to the primary business activities (e.g. production, marketing and selling, administration) in which the item is generated or used. The disaggregation of items by nature refers to the economic characteristics (e.g. nature of input factor) of different items. In addition, even similar items by function and nature should also be separated in the financial statements if different measurement bases are applied to these items (e.g. subdivision of financial instruments in those measured at amortised cost and those measured at fair value).

According to the cohesiveness principle the entity shall present information in a manner that the relationship among items and subtotals across the financial statements are clear.6 As the statement of changes in equity focuses only on a part of the balance sheet the cohesiveness principle applies only to the balance sheet (statement of financial position), the statement of comprehensive income, and the statement of cash flows. In the interaction with the disaggregation principle, both principles lead to an approximative uniform structure of sections, categories and even subcategory in the financial statements.7 At least, all these three financial statements are subdivided identically in a business section, a financing section, an income tax section and a discontinued operation section; thereby the business section itself is once more subdivided identically in an operating and an investing category.

The classification process of the different items shown in the financial statements starts on the classification of the assets, liabilities and equity in the statement of financial position. These items are fundamental and are logically prior to the items recognised in the statements of comprehensive income and cash flows.8 However, in determining the section, category or subcategory in which to classify an asset or liability, an entity must consider the activity in which the asset or liability is used; consequently, the functional activities depicted in the statements of comprehensive income and cash flows are part of the classification process.9

2.2.1 Overview

More detailed, schedule 1 presents the structure of the individual financial statements according to the proposals of the SD-FSP:

Schedule 1: Structure of the financial statements according to the SD-FSP

In the operating category items are classified, which arise in the entity’s day-to-day business.10 This definition includes also the purchase and the sale of long-lived assets which are used in the production process of the entity. Only in the statements of financial position and comprehensive income an operating finance subcategory exists. This subcategory includes the financing activities which are directly related to an entity’s operating activities and which provide also a source of long-term financing for the entity.11 In the statement of financial position, examples are the net post-employment benefit obligations, lease obligations, or decommissioning liabilities.12 In the statement of comprehensive income, only the income and expenses related directly to the finance aspect of a liability or a net asset classified in the operating finance subcategory, such as interest expense, accretion expense or the return on pension plan assets shall be classified in that subcategory.13

An asset or a liability that an entity uses to generate a return and any change in the value of that asset or liability shall be classified in the investing category. In addition there are no significant synergies created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity.14 For an industrial or a non-financial services entity, examples are the purchase, the use, and sale of investments, including investments in associates and joint ventures, investment property or financial assets.

The financing section includes all items that are part of an entity’s activities to obtain (or to repay) capital15, except those liabilities that are classified in the operating category, the operating finance subcategory or in the discontinued operation section. Irrelevant for the classification of the items in the financing section is the use for specific activities. As the statement of comprehensive income aims to calculate the profit and loss and the comprehensive income attributed to the shareholders, the financing section of this statement includes only the financing from debts. In the other two financial statements the financing section includes both, the financing from equity and from debts. Furthermore, in the statement of financial position the financing section is subdivided in the debt and the equity category in order to present the entity’s equity unchanged to the current disclosure.

Although each of the financial statements contains an income tax section, its extent varies. In the statement of financial position the income tax section includes all current and deferred income tax items. As the statement of cash flows presents cash receipts and cash payments, in the income tax section of this financial statement, only effective income taxes can be presented. Despite of the separate presentation of an income tax section in the structure of the statement of comprehensive income the principles of allocating income tax expense or benefit in accordance with IFRSs still prevail. Therefore an entity has to present income tax expense or benefit in the discontinued operation section or in the other comprehensive income part of the statement of comprehensive income if the corresponding items that triggered these tax effects are presented in those parts of the statement of comprehensive income.16

The discontinued operation section presents all assets, liabilities, income, expenses and cash flows which are disclosed as “discontinued operations” according to IFRS 5.17 In comparison to the present situation, in the statement of financial position the joint disclosure of assets classified as held for sale and assets included in disposal groups classified as held for sale, including discontinued operations, and of the liabilities included in disposal groups classified as held for sale, also including discontinued operations, will be removed.18 In the discontinued operation section, only those assets and liabilities will be shown which are related to a discontinued operation according to IFRS 5. The other assets and liabilities which belong to a disposal group but not to a discontinued operation will be presented outside the discontinued operation section, most probably in the investing category. Therefore over all financial statements, the consistency in the disclosure will be improved significantly by that change.

2.2.2 Pecularities of the structure of the financial statements

In addition, due to the different objectives of the single financial statements each one has some pecularities in its structure:

For the statement of financial position, the pecularities in the structure are:

• operating finance subcategory,

• subdivision of the financing section in a debt and an equity category19, and

• in general20, classification of assets and liabilities as short-term or long-term items according to their maturity or their expected date of realisation or settlement.21 In the opposite to the present situation22, the length of the “normal operating cycle” has not any relevance for the classification of assets and liabilities as short-term or long-term. Furthermore, also the income tax assets and income tax liabilities have to be subdivided in that manner.23

The pecularities of the structure of the statement of comprehensive income are:

• Paramount to the subdivision in sections, categories and subcategory is the presentation of the statement of comprehensive income in two parts, the income statement and the other comprehensive income, whereby the items of the other comprehensive income are classified in those which will never be reclassified subsequently to profit or loss and those which will be reclassified subsequently to profit or loss when specific conditions are met.24 Therefore, the subdivision in sections, categories and subcategory follows on the next level. In general, even all items of the other comprehensive income have to be allocated to the operating category (including the operating finance subcategory), the investing category, the financing section or the discontinued operation section.25 The one and only exception is the foreign currency translation adjustment of a consolidated subsidiary (or a proportionate consolidated joint venture26).27

• Multi-category transaction section: Not only the statement of comprehensive income but also the statement of cash flows contain a multi-category transaction section. In this section of those financial statements the net effects on comprehensive income or cash flows of an acquisition that results in the recognition of assets and liabilities in more than one section or category in the statement of financial position shall be classified. Similarly, the net effects of a disposal transaction (that is not a disposal of a discontinued operation) resulting in the derecognition of assets and liabilities in more than one section or category in the statement of financial position shall also be classified in the multi-category transaction section of the statements of comprehensive income and cash flows.28

• income tax allocation in the statement of comprehensive income and

• a separate operating finance subcategory29.

Furthermore, according to SD-FSP.155 all unusual or infrequently occurring items shall be presented separately in the appropriate section, category or subcategory in the statement of comprehensive income. This disclosure requirement is supplemented by the note information

about remeasurements. In this note the entity shall present the different types of remeasurements (at least separation of regular remeasurements, e.g. fair value adjustments of financial assets at fair value through profit or loss or investment properties, and irregular remeasurements, e.g. impairment losses for long-lived assets, including goodwill) in each section, category and subcategory of the statement of comprehensive income.30

As already mentioned, the pecularity of the structure of the statement of cash flows is the multi-category transaction section. Beside it, the main change in the statement of cash flows is the cancellation of the choice of presenting cash flows from operating activities using either the direct or the indirect method31. According to SD-FSP.168 and 170 an entity shall present its gross cash receipts and gross cash payments in all sections and categories of the statement of cash flows. Although the direct method of presenting the statement of cash flows is only permitted the preparers of the financial statements are allowed to use a direct-indirect approach to set up this statement.32 This method starts with the preparation of the statement of cash flows using the indirect approach. In the next step the profit or loss in that statement of cash flows is substituted by the income and expenses of the income statement. In the following steps these income and expenses are netted against the change of the particular corresponding balance sheet items in order to derive approximately the cash receipts and the cash payments.33

Example:

The sales revenue of the reporting period amounts to 10.000 currency units (CU), the other operating expenses (including an increase of the valuation allowance of the trade receivables by 100 CU) amount to 1.000 CU. After deducting the valuation allowance the balance sheet item trade receivables increased during the reporting period by 500 CU.

As the increase of the valuation allowance by 100 CU has no cash effect at all the other operating expenses must be reduced by 100 CU in order to derive the other operating payments; this amount is netted against the change of the balance sheet item trade receivables (1). After this reclassification has taken place, the rise of the trade receivables by 600 CU is charged against the sales revenue because to the extent the trade receivables increase no cash receipts from sales are generated by the entity (2).

Schedule 2: Deriving the statement of cash flows by using the direct-indirect approach

3.1 Analysis of the financial position

Due to the proposed structure of the financial statements users get additional information about the constitution of the entity’s assets. Assets and liabilities are not only subdivided by their function but also by the period of time to be realised or settled. As already mentioned34, only those assets or liabilities are classified as short-term if either their contractual maturity or their expected date of realisation is within one year of the reporting date. All other assets and liabilities are classified as long-term items.35 According to the present disclosure rules the classification of balance sheet items as short-term or long-term items is based also on the length of the entity’s normal operating cycle36, so that even assets and liabilities which will be realised or settled in years could be classified as short-term if the entity’s normal operating cycle covers several years (e.g. whisky distillery). As the financial ratios that describe the financial position (e.g. short-term and long-term solvency ratios37) also require a subdivision of balance sheet items based on the length of time for realisation or settlement these ratios could be determined easily if the classification of the SD-FSP applies. In this case there will be no need of using any simplistic assumptions.

Furthermore, due to the proposed structure of the statement of financial position users get better information about the non-operating assets which are shown in the investing category and the discontinued operation section. The separate disclosure of the non-operating assets in two segments of the statement of financial position reflects the different intentions of the entity to dispose those assets. From an economic point of view, these non-operating assets indicate the amount of assets the entity can dispose without endangering to the entity’s core business. Although the book value of the non-operating assets will not be equivalent to the corresponding sales proceeds, nevertheless in many cases the valuation of the assets in the investing category and in the discontinued operation section at the measurement bases according to current IAS/IFRS38 may be at least a reasonable appraisal for the expected cash inflows. The proceeds from the disposal of the non-operating assets could be spend for repayments of liabilities, for investing in the operating or investing category, or for repayments to the shareholders.

In addition, the subdivision of the liabilities in different sections and categories enables users of the financial statements to evaluate the possibilities of reducing the entity’s debts. The liabilities classified in the discontinued operation section and in the investing category are in most cases closely linked with the corresponding assets classified in the discontinued operation section resp. in the investing category. Therefore these liabilities will most probably be extinguished by a disposal of the corresponding assets. In the opposite, as the liabilities classified in the operating finance subcategory are directly linked with the entity’s core business there are only limited possibilities of reducing those debts.

3.2 Analysis of the financial performance

3.2.1 Calculation of “sustainable” profits

Schedule 3 shows the possibilities of classifying income and expenses by using the proposed structure of the statement of comprehensive income if income and expenses are subdivided by their different origin and regularity.

Schedule 3: Possibilities of classifying income and expenses

Due to the separate disclosure of all unusual and infrequently occurring items, and the note information about the regularly and not regularly recognised remeasurement effects for each section, category and subcategory of the statement of comprehensive income39 users are enabled to calculate “sustainable” profit

ratios (for each section or category). The users can arrange the “sustainable” profits

according to their assessments regarding the sustainability of several classes of income and expenses. If a close definition is applied the sustainable profits include only the “income and expenses (residual amounts)” in schedule 3 (profit from continuing operations before all remeasurement effects and before unusual and infrequently occurring items). If users and financial analysts prefer a broader approach sustainable profits could also contain the regular remeasurement effects which are recognised at the end of each reporting period. As in general income and expenses of the other comprehensive income are classified in sections and categories in the same way as in the income statement, and the note information regarding the remeasurements in each section and category even applies for the other comprehensive income40, users can also include in their definition of sustainable profits (from the sections and categories) the regular remeasurement effects recognised in the other comprehensive income. Moreover, users can distinguish between the remeasurement effects in the other comprehensive income from items that will be reclassified subsequently in profit or loss when specific conditions are met and the other comprehensive income from items that will not be reclassified subsequently in profit or loss.

See sect. 2.2.2.

See SD-FSP. 233 sent. 2.

3.3 Analysis of cash flows

At first sight the change in the structure of the statement of cash flows seems to be not as significant compared with the changes in the structure of the other two financial statements, nevertheless the extent and the substance of the cash flows presented in the statement of cash flows according to the SD-FSP are quite different compared to the current situation. One reason is that the statement of cash flows is prepared by using the direct approach43. The IASB argues that the presentation of cash flows by using the direct approach is advantageous because it

• is more intuitive and understandable to a broad range of users of financial statements,

• improves the ability to predict future cash flows,

• improves insight into an entity’s cash conversion cycle and the relationship between revenues and expenses presented in the statements of comprehensive income and cash flows,

• when accompanied by a reconciliation of operating cash flows to operating income, links the statement of financial position and the statement of cash flows.44

As already mentioned45, the extent of the operating category is completely different compared with the current definition of the cash flows from operating activities. Therefore the cash flows from operating category include also the capital expenditures for tangible fixed assets or intangibles used for running the entity’s core business and corresponding to this the proceeds from the sale of those long-lived assets. (The only exceptions are the payments for the acquisition of assets which have to be classified in the multi-category transaction section43 and analogous to this the proceeds from the disposal of assets classified in more than one section or category.) As the capital expenditures for the acquisition of long-lived assets that could be attributed directly to the operating category and also the proceeds from the sale of these assets are classified in the operating category the cash flows from operating category might be called as the entity’s “operating free cash flows”. At present, the free cash flows could only be calculated approximately by adding up the cash flows arising from operating activities and from investing activities.47 As the cash flows from operating category (i.e. “operating free cash flows”) do not contain the cash flows from other entrepreneurial activities that do not belong to the entity’s core business, for financial analyses, the cash flows from operating category are much more suited than current approximative computations of the entity’s free cash flows.

Due to the changed content of the cash flows the predicative value of a lot of cash flow ratios that are based on the cash flows from operating category will be improved. The cash flows from operating category can be assumed to be a more realistic appraisal for the facilities of the entity to repay debts or to pay dividends, and in the case of negative cash flows from operating category for the need of additional capital. A further example is the “operating cash flow to total liabilities ratio”48; this ratio is used to estimate the period of time an entity needs for paying back all its debts. By applying the proposed structure of the financial statements this ratio could be determined as the proportion of cash flows from operating category to the liabilities classified in the financing section. Under the simplistic assumption that the cash flows from operating category are constant over the next years, this ratio indicates the number of years the entity needs to extinguish completely its liabilities shown in the financing section. In comparison to the traditional computation, this ratio takes into account the need of cash flows to be invested in the operating category (especially capital expenditures for tangible fixed assets or intangibles) as the cash flows from operating category include those payments. Moreover, this ratio focuses only on the liabilities classified in the financing section and excludes consciously those liabilities which are directly linked with the entity’s core business (i.e. operating finance subcategory). Therefore, the appraisal for the period of extinguishing the entity’s debts is more realistic.

Furthermore, due to the cohesiveness principle ratios that bring subtotals of the financial statements in relation to each other are additional examples for the enhanced possibilities of financial statements analysis. Beside the cash flows from operating category to the liabilities classified in the financing section ratio, further examples are the cash flow margin on sales (i.e. proportion of cash flows from operating category and the sales from operating category) or the cash flow return on operating or investing assets (i.e. proportion of cash flows from operating or investing category and the assets from the respective category).

(1) Exceptions from a complete cohesive structure over all financial statements

Although the structure follows the cohesiveness principle to a large extent nevertheless there exist some exceptions due to factual or practical reasons. The main exceptions from a complete cohesive structure of the statements of financial position, comprehensive income and cash flows are listed in sec. 2.2.2 of this article as pecularities of the structure of the financial statements. The incomplete cohesive structure of the financial statements prevents additional analyses or biases the predicative value of some financial ratios. For example, due to the implementation of a multi-category transaction section in the statement of comprehensive income not all gains and losses of the disposal of assets and liabilities which could be attributed to the business (including operating and investing category) and financing sections are classified in these sections and instead of it included in the multi-category transaction section. As in the statement of financial position no multi-category transaction section exists numerator and denominator of the “return on assets” ratios49 are not entirely consistent.

(2) Classification of assets and liabilities with multiple functions

The Boards acknowledge the problem of classification of assets and liabilities that are used for more than one function. “For example, an entity’s headquarters building might be used as part of the entity’s operating activities and it might also be a real estate investment.”50 In this case the Boards propose that the entity shall classify such assets and liabilities with multiple functions in the section or category of predominant use.51

Even if this solution can be accepted for practical reasons, and also the case of two approximative equivalent important uses is neglected which includes some kind of discretionary decision, the problem of classifying income, expenses, cash inflows, and cash outflows related to the asset resp. liability with more than one use still remains. In the case of classifying the entity’s headquarters building in the investing category, according to SD-FSP. 137 and 168 also the income and expenses, and the cash flows which are related to this asset have to be classified in the investing category. Nevertheless, this classification of the entity’s headquarters building biases the picture of the entity’s performance in both, the operating, and the investing category. Regarding the operating category, no expenses for using the entity’s headquarters building are recognised in the operating category although the building is used for the entity’s core business. These expenses attributable to the operating category reduce the profit from investing category. From an economic point of view, rents for the use of the building for purposes of the operating category must be charged from the investing to the operating category. If the operating and the investing category are organised in different legal business units rents can be charged without any difficulties. In the other case this problem could not be solved as the SD-FSP does not allow to present “hypothetical inter-category” income or cash flows.

(3) Subdivision of the statement of comprehensive income in two parts

The SD-FSP deals only with the presentation and the disclosure of the financial statements, including corresponding note information, and does not care about related questions of recognition at all. Therefore in the SD-FSP, the separation of the income statement and the other comprehensive income part of the statement of comprehensive income still remains. The IASB acknowledges the problem of a missing conceptual basis for subdividing income and expenses in the statement of comprehensive income but without giving any perspective for solving this matter. “To address this issue, the IASB attempted to find a common conceptual basis but feedback suggests that it would be very difficult to do so in the short term.”52 Due to this, all judgements that management has to exercise in the process of applying the entity’s accounting policy retain their relevance for classifying income and expenses in the different parts of the statement of comprehensive income (e.g. classification of financial assets according to IAS 39 depending on the managerial intentions and on application of the fair value option, application of hedge accounting depending on the documentation of the requirements according to IAS 39.8853).

Furthermore, unchanged to the current disclosure the entity has the choice of presenting the assets and liabilities based on liquidity instead of presenting balance sheet items based on the length of period to be realised or settled (current and non-current items) depending on which kind of presentation provides more relevant information.54 Despite of this choice, according to IAS 1.61 the entity has to disclose in the notes for each asset or liability line item that combines amounts expected to be recovered or settled, (a) no more than twelve months after the balance sheet date, and (b) more than twelve months after the balance sheet date, the amount expected to be recovered or settled after more than twelve months. Therefore even in the case the entity presents assets and liabilities in the statement of financial position based on liquidity, users can approximately derive the balance sheet structure based on the length of time for realisation or settlement. The SD-FSP cancels the note information of IAS 1.6155. Corresponding to this in the case of presenting the assets and liabilities based on the liquidity, users and financial analysts will no more be able to determine the financial ratios that are usually used to describe the entity’s financial position56.