An academic overview of the Primary Financial Statements project

International Accounting Standards Board (Board) members Ann Tarca and Tom Scott provide an overview for academics of the Primary Financial Statements project.

Introduction

The Primary Financial Statements project is intended to help users to better understand and compare information published in companies’ general-purpose financial statements.1

The Board’s proposed changes in relation to the statement of financial performance will specify how some items should be classified and require more subtotals to be presented. The proposed changes would also provide users with more precise information through a better disaggregation of income and expenses. The recommended changes in relation to the cash flow statement will require a common starting point for the reconciliation of operating cash flows and will replace current options for the presentation of interest and dividends with a single presentation.

The Board expects these changes to improve the usefulness of information by improving users’ ability to evaluate companies over time and to compare companies. Users have told us they need information that is comparable, but they also find company-specific information that complements the IFRS information useful. Accordingly, the Board proposes requiring companies to provide information that increases the transparency of and discipline around management-defined performance measures that help users understand these measures.

Taken together, the proposed changes are intended to help companies provide useful information to users of financial statements and focus on improving the comparability, understandability and relevance of the information provided.2

What is the problem?

Users have expressed concerns that the structure and content of the statement of financial performance varies among companies, even within the same industry. Many companies present operating profit subtotals; however, companies often calculate these subtotals differently. For example, the set of expenses that are presented as operating expenses varies between companies as does the presentation of finance income and expense.

Users have noted different presentation practices in the statement of cash flows. The starting point for reconciling operating cash flows and the presentation of interest and dividends varies among companies. Users have reported that these inconsistencies can make comparing companies difficult.

Users prefer more consistent and complete reporting of financial performance measures. Regulators and standard-setters also support more structure and disaggregation of information. Both preparers and users agree that more disaggregation would be useful. A CFA Institute report suggests that management-defined company-specific performance measures are, in part, a response to inadequate classification, insufficient subtotals and insufficient disaggregation in the financial statements.3

Many companies have chosen to disclose adjusted earnings measures that provide management’s view of performance to complement measures defined in IFRS Standards. While sometimes presented in the statement of financial performance, these measures more often appear in management commentary or in press releases. The nature and magnitude of the adjustments to earnings vary among companies and, for a single company, may vary over time. Users have expressed concern over such inconsistency and lack of transparency.

Many preparers have expressed support for including measures of performance beyond those required by IFRS Standards in the audited financial statements. They emphasised the need for companies to be able to ‘tell their own stories’. Some users advised that they find measures of earnings reflecting a ‘management view’ useful, particularly if accompanied by transparent details about the measures’ components and a reconciliation to relevant totals or subtotals defined by IFRS Standards.

Users are interested in management’s story about performance; they are especially interested in management’s ability to sustain profitable operating activities and management’s stewardship of the company’s resources. Accordingly, both preparers and users describe management performance measures as useful complements to performance measures specified by IFRS Standards. Users would, however, prefer to spend less time searching for this information. They would also appreciate complete and transparent reconciliations that would enhance their understanding and ability to make comparisons among companies.

Enhancing usefulness through improvements to the primary financial statements

In addition to the feedback received from stakeholders, we have gathered other evidence that suggests the usefulness of financial information could be enhanced by changes to requirements of IFRS Standards relating to the presentation and disclosure of information in the financial statements. The evidence relates to presenting subtotals, removing reporting options in the cash flow statement, and improving disaggregation. 

Subtotals

Evidence from practice and academia shows widespread use of subtotals and provides evidence of their importance to users. An August 2016 Mazars study of EUROSTOXX 50 companies reported that all 32 industrial companies surveyed reported earnings before interest and tax (EBIT), usually as a subtotal in the statement of financial performance.4 However, the subtotals’ labelling and calculation were inconsistent. In calculating EBIT, 35% included the share of profit or loss from investments accounted for using the equity method, while 65% excluded this item. Forty-six per cent of companies reported earnings before interest, tax, depreciation and amortisation (EBITDA), with 12% showing it as a subtotal in the statement of financial performance.

Research has shown that financial reporting numbers are collectively at least as relevant today as they were in the 1950s or 1960s. However, research also suggests that a single bottom-line summary statistic on its own, such as net profit or loss, is not enough in today’s complex and dynamic world.5 A CFA Institute survey showed that a majority of respondents (55%) expected standard-setters to define key subtotals, such as operating profit, EBIT and EBITDA.6

Research based on company reporting according to IFRS Standards showed these subtotals are value relevant—associated with share prices—implying they are useful for investors.7 Research has investigated the line items and subtotals presented by companies from 46 countries and concluded that value relevance is highest for measures in the ‘middle’ of the income statement, for example, operating profit.8

To enhance the usefulness of financial statements prepared using IFRS Standards the Board will propose additional subtotals, including an operating profit subtotal and a subtotal of profit before financing and income tax. These subtotals will effectively demarcate operating, investing and financing activities on the statement of financial performance.9 It is likely that the additional information provided by these subtotals will capture some of the information presently provided in management performance measures. If so, this will likely decrease, but not remove, the need for management performance measures. Improved subtotals should lead to better classification and disaggregation of financial information and a more faithful representation of the diverse aspects of performance, thereby facilitating the preparation of a thorough financial analysis. 

Removing optional presentation

Research supports changes to IAS 7 Statement of Cash Flows because, as currently applied, the Standard leads to diversity in companies’ presentation of interest and dividends. A study of 798 companies from 13 European countries showed that in operating cash flows, 76% included interest paid, 60% included interest received and 50% included dividends received. The authors concluded that such diversity in presentation hinders the comparability of reported operating cash flows.10 Further, operating cash flows are increasingly important for valuing companies and are an important complement to net profit or loss.11

Survey research conducted by the UK Financial Reporting Council regarding the statement of cash flows showed support for the reconciliation of cash flows from operations to a subtotal in the statement of financial performance representing operating profit.12

The Board’s proposals specify a consistent starting point for reconciling cash flows from operating activities and remove options for the presentation of interest and dividends paid and received. 

Disaggregation

Researchers and analysts argue that disaggregation can enhance the amount of information available to users and others. Some conclude that the lack of precision in standards for disaggregation affects the information content of financial statements and can have major effects on comparability of companies from different jurisdictions.13 The Board’s Primary Financial Statements project will propose principles and definitions for aggregation, disaggregation and classification and provide guidance on the application of these principles. 

More, and more relevant, subtotals that are consistently calculated can improve financial reporting across companies and over time. In addition, the Board will propose that unusual items are separately disclosed.14 These improvements, combined with improved principles for disaggregation, should lead to companies’ financial statements providing better information for users who make financial decisions. 

A majority of analysts surveyed by the CFA Institute believe that better-defined structures in each of the statement of financial performance and statement of cash flows will reduce the need for alternative performance measures.15 For some companies, users may benefit from company-specific management performance measures that complement the proposed improvements to the financial statements. Accordingly, the Board’s project also examines how to increase the transparency and discipline of additional company-specific information available from management performance measures. 

Increasing the transparency of and discipline around company-specific management performance measures 

The Board is likely to propose that a company should be required to report in a note information about performance measures that the company uses in its public communications which, in the view of its management, complement IFRS-defined subtotals in communicating the company’s financial performance. These performance measures are management performance measures.

The proposals would support best practice recommendations from regulators by requiring a description of the measure, appropriate labelling, an explanation of why management believes the measure is useful in communicating financial performance, and period-to-period consistency. In addition, management performance measures will be subject to the general requirement of faithful representation. Companies will be required to provide a complete and transparent reconciliation to the most directly comparable subtotal or total specified by IFRS Standards and to describe clearly how it has been calculated.

Many companies provide company-specific measures of adjusted earnings. Various studies have investigated how much these measures are used. A study by Mazars in 2016 reported that while 86% of companies provided an adjusted earnings measure, 63% of these companies did not disclose the measure in the statement of financial performance. Seventy-six per cent of companies reconciled their alternative performance measure to the relevant measure specified by IFRS Standards, but only 62% of these separately identified and clearly explained the reconciling items.

In the banking segment, six of eight companies reported operating or adjusted operating profit on the face of the statement of financial performance. The banking sector featured a wider range of alternative performance measures than featured by other industries. All four insurance companies in the study reported either an operating result or an adjusted earnings subtotal. Two insurers presented this subtotal on the face of the statement of financial performance. 

The use of adjusted earnings measures is observed in many jurisdictions that have adopted IFRS Standards. A KPMG study of 270 large listed companies from 16 countries that have adopted IFRS Standards found that 52% of annual reports provided a non-GAAP measure of performance.16 In some jurisdictions, the use of adjusted earnings measures has increased over time.17

A global CFA Institute survey reported that analysts found non-GAAP earnings measures useful in many ways, including as a valuation input, an indicator of accounting quality, and as a starting point for company analysis.18

Academic studies show that adjusted earnings measures are useful for investors. It is likely that these measures provide information that assists evaluation of the quality and persistence of earnings. Researchers have also concluded that reconciliations between adjusted earnings and earnings defined by accounting standards provide useful information for investors.19

Concerns about adjusted earnings measures and improving financial reporting

At present, regulation of adjusted earnings measures is provided by national securities regulators. However, the regulations vary across jurisdictions and the measures are not normally subject to audit. Academic evidence suggests that regulatory interventions by the US Securities and Exchange Commission have improved the quality of management’s adjusted earnings measures. After the interventions, these measures are more informative and are used less for opportunistic reasons.20 Nevertheless, there is room for improvement.

Analysts continue to express concerns about the communication, consistency and comparability of adjusted earnings measures across companies and over time. Specific issues relate to the quality of the reconciliation of the adjusted earnings to items required by IFRS Standards and inadequate disclosures about the adjustments. Concerns persist over the transparency of adjusted earnings measures and some management adjustments that appear to be inappropriate or opportunistic. 

Users support enhancing the quality of adjusted earnings measures, while at the same time limiting opportunistic behaviour.21 A recent survey of CFA Institute members reported that the majority of respondents (63%) held the view that management’s alternative performance measures should be regulated; 59% of respondents expected that standard-setters should set standards for such measures.22 CFA Institute members also strongly support reporting such additional performance measures in financial statements where they would be subject to audit, which should also result in enhanced internal controls.23

The proposals, if implemented, will result in a single set of requirements for including management performance measures within the financial statements which should result in greater consistency in reporting by companies using IFRS Standards. A company that uses these measures to complement its IFRS performance measures will provide in its financial statements additional company-specific information that otherwise might be omitted. Collectively, the changes proposed by the Primary Financial Statements project should provide a significantly better depiction of a company’s performance. 

Conclusion

The Primary Financial Statements project will respond to demands from users for better and more comparable financial information. The Board proposes improvements to both the statement of financial performance and the statement of cash flows. The changes will include improved classification with more subtotals, more consistent reporting of subtotals and better disaggregation. These improvements respond to an increasingly complex and dynamic world that requires more precise and detailed information, and whenever possible, information that remains comparable across companies and over time. The improvements will increase the financial statements’ relevance, understandability and comparability. 

The Board’s proposed improvements will provide more and better information that should reduce, but not eliminate, the need for management performance measures. These measures can complement the financial performance information specified by IFRS Standards. Some companies will continue to use management performance measures to provide company-specific information. 

Bringing management performance measures within the audited financial statements should enhance their transparency and discipline. The proposed improvements to the financial statements together with the incorporation of company-specific management performance measures, when disclosed by a company, should produce a more complete and useful set of financial information for companies and users around the world.

The views expressed in this article are those of the authors, not necessarily those of the International Accounting Standards Board or the IFRS Foundation.


1See paragraph 1.2 of the Conceptual Framework for Financial Reporting, issued in March 2018, which states: ‘The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.’ The terms ‘financial reports’ and ‘financial reporting’ refer to general purpose financial reporting unless otherwise indicated.
2For more information, see the preliminary views of the International Accounting Standards Board (Board) summarised in the IFRS Staff Paper ‘Primary Financial Statements: Moving from the Research Agenda to Standard-setting’, ASAF Agenda Reference 2, July 2018. 
3CFA Institute, ‘Alternative Performance Measures—The Latest on Investor Use and Desire for Standardization’, CFA Institute Member Survey Report, 2018.
4Mazars, ‘The Use of Alternative Performance Measures in Financial Information: Current Practices of European Listed Entities’, November 2016.
5Paper presented to the Board. Mary E. Barth, Ken Li and Charles McClure, ‘Evolution in Value Relevance of Accounting Information’, Stanford University Graduate School of Business Research Paper, No. 17-24, 7 May 2018. Available at SSRN: https://ssrn.com/abstract=2933197 or http://dx.doi.org/10.2139/ssrn.2933197.
6CFA Institute, ‘Bridging the Gap: Ensuring Effective Non-GAAP and Performance Reporting’, November 2016.
7Paper presented to the Board as part of the KPMG/IAAER research programme. Greg Clinch, Ann Tarca and Marvin Wee, ‘The Value Relevance of IFRS Earnings Totals and Subtotals and Non-GAAP Performance Measures’, 8 March 2018. Available at SSRN: https://ssrn.com/abstract=3178567 or http://dx.doi.org/10.2139/ssrn.3178567.
8Paper presented to the Board as part of the KPMG/IAAER research programme. Jan Barton, Thomas Bowe Hansen and Grace Pownall, ‘Which Performance Measures Do Investors Around the World Value the Most—and Why?’, The Accounting Review, May 2010, 85(3), pp. 753–89.
9The subtotals will not integrate precisely with the categories on the cash flow statement.
10Elizabeth A. Gordon, Elaine Henry, Bjorn N. Jorgensen and Cheryl L. Linthicum, ‘Flexibility in Cash-flow Classification Under IFRS: Determinants and Consequences’, Review of Accounting Studies, June 2017, 22(2), pp. 839–72.
11Barth, Li and McClure, ‘Evolution in Value Relevance’.
12Financial Reporting Council, ‘Feedback Statement—Discussion Paper Improving the Statement of Cash Flows’, July 2017.
13Presentation at ICAEW Better Markets Conference. Robert Libby and Scott A. Emett, ‘Earnings Presentation Effects on Manager Reporting Choices and Investor Decisions’, Accounting and Business Research, July 2014, 44(4), pp. 410–38.
14The tentative definition for unusual items is: ‘Unusual items are income or expenses with limited predictive value because it is reasonable to expect that similar items will not arise for several future annual reporting periods. Similar items are income or expenses that are similar in type and amount.’ See AP21, May 2019 (p. 10), available at https://www.ifrs.org/-/media/feature/meetings/2019/may/iasb/ap21-pfs.pdf.
15CFA Institute, ‘Bridging the Gap’.
16KPMG, ‘Room for Improvement: KPMG Second Survey of Business Reporting’, KPMG International, 2016.
17Clinch, Tarca and Wee, ‘The Value Relevance’.
18CFA Institute, ‘Investor Uses, Expectations and Concerns on Non-GAAP Financial Measures’, September 2016.
19See literature reviews: Dirk E. Black, Theodore E. Christensen, Jack T. Ciesielski and Benjamin C. Whipple, ‘Non-GAAP Reporting: Evidence from Academia and Current Practice’, Journal of Business Finance & Accounting, 2018, 45(3–4), pp. 259–94; and Ana Marques, ‘Non-GAAP Earnings: International Overview and Suggestions for Future Research’, Meditari Accountancy Research, 2017, 25(3), pp. 318–35.
20Black, Christensen, Ciesielski and Whipple, ‘Non-GAAP Reporting’; and Marques, ‘Non-GAAP Earnings’.
21CFA Institute, ‘Bridging the Gap’.
22CFA Institute, ‘Alternative Performance Measures—The Latest on Investor Use and Desire for Standardization’.
23CFA Institute, ‘Bridging the Gap’.

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