20 June 2019

Strengthening the relevance of financial reporting

Hans Hoogervorst

When: 20 June 2019

Where: IFRS Foundation Conference, Leonardo Royal Hotel, London, June 2019

Chair of the International Accounting Standards Board (Board) Hans Hoogervorst delivered the keynote speech at the IFRS Foundation Conference 2019 in London, UK. In it he outlines the Board's plans to maintain and strengthen the relevance of financial reporting in two specific areas—primary financial statements and management commentary.

Introduction

The year 1958 saw the publication of the Italian novel The Leopard (Il Gattopardo), which became the top-selling book in Italian history. Unfortunately, its author, Giuseppe di Lampedusa, died before the book was published, so he—like Vincent van Gogh—never witnessed the success of his creation. One line in the book lives on until today: ‘For everything to stay the same, everything must change’.

Remaining relevant in a changing world is a challenge for all of us. Whether you work in publishing, finance, transportation, or accounting, remaining relevant means continuing to adapt to a changing world.

In the world of IFRS Standards, change has been a constant pretty much since we started back in 2001. First, we had to knock the inherited Standards into shape, in time for EU adoption in 2005. Then, we had to deal with our response to the financial crisis, while in parallel completing the major upgrades to the accounting for financial instruments, revenue recognition, lease accounting and most recently, insurance contracts.

Most of that work is behind us, although we now spend a great deal of time supporting consistent application of these major Standards. However, just because the big reforms are done, it doesn’t mean that change is no longer required. 

There is plenty going on around us. There is the changing nature of companies—the knowledge economy driving huge growth in intangibles, for example. There is also the proliferation of non-GAAP measures and greater interest in broader corporate reporting, particularly in the sustainability space. And there is the impact of technology; how it affects the preparation and consumption of financial information. 

These are all important developments, but they do not change the fundamental essence of financial reporting. IFRS is a capital market standard, and in that market it is the bottom line that ultimately counts. Because of the comparability and discipline of our Standards, the income statement according to IFRS Standards will always remain the main anchor for investors in predicting future cash flows.

However, for the reasons I mentioned, we do need to ensure that IFRS remains relevant in this changing world. So, this afternoon I’d like to share with you our plans to maintain and strengthen the relevance of financial reporting in two specific areas.

First, I will talk about what we are doing with the Primary Financial Statements project (PFS). This project is all about improving the structure and the communication effectiveness of financial statements. PFS really could be a game-changer.

Then, I will talk about the Management Commentary project, which is our main vehicle for considering broader developments in reporting and how they relate to the financial statements.

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. 

So, what are we proposing to do?

New subtotals

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 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.

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.  

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. 

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. 

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. 

Impact

I believe the aggregate impact of our proposals on the quality and usefulness of the income statement will be quite substantial. The PFS proposals will create more structure in the income statement and will enhance comparability. The improved structure will make it much easier for users to find the components for the analysis that they prefer. It will also facilitate digital consumption of financial information. 

Moreover, over time 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. Preparers might wish to reduce the need for reconciliation and decide to stick to the IFRS-subtotals. 

The increased discipline around MPMs and unusual items will decrease the room for unbalanced presentation. 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? While we accept that non-GAAP is here to stay, I expect that its use—and certainly its abuse—will diminish over time.  

Management commentary

So far, I have discussed relevance within the context of the financial statements and the notes. Let’s now take a step back and look at other developments that are relevant to investors but are not easily captured by the financial statements.

While the primary financial statements will remain the cornerstone of our work, the Board has always recognised their limitations. For example, the financial statements provide little information about a company’s business model or the economic environment it is operating in.

They also do not contain information about all the intangible resources and relationships that drive business success. Some of this information is excluded from the financial statements for good reasons. Trying to capture the value of intangibles is a hugely subjective exercise and would pose enormous recognition and measurement challenges.

The financial statements also contain limited forward-looking information, including information on emerging sustainability issues. This makes it very difficult for investors to see whether a company is prioritising short-term financial targets at the expense of longer-term value creation that is not immediately reflected in the financial statements. That can lead to capital being diverted from companies pursuing long-term strategies in favour of those prioritising short-term earnings.

Responding to investors’ needs, in 2010 we published what we call our Management Commentary Practice Statement—basically a non-mandatory guide for how to write the front of an annual report. It should help management provide a broader context for the financial statements, which is why I like to refer to broader financial information.

Since 2010, a lot has happened in this space. As the technology giants have taken off, there is much more interest in the impact of intangibles. The management commentary section of the annual report is an appropriate vehicle for providing information on intangibles. 

Moreover, there have been other developments in corporate reporting. The International Integrated Reporting Council launched its <IR> Framework. Many advances have been made in the environmental, sustainability and governance (ESG) reporting space, none of which was anticipated by our own Practice Statement. However, we continue to hear concerns from investors over the quality and focus of information that they are receiving.

For the Board, strengthening relevance of financial reporting means finding a way to help investors better understand the financial impact of aspects of business performance that cannot be adequately captured in the financial statements. The way we will achieve this is through an update and upgrade of the Practice Statement.

The updated Practice Statement will remain primarily focused on the broader financial information needs of investors. We want companies to report on what is strategically important to them, including how remuneration policies align with their long-term objectives. There will be more focus on intangibles that underpin companies’ long-term success. And of course, companies would be expected to tell how sustainability issues, including climate change, may impact their business if that impact is material. 

Close

Let me come to a close. Remaining relevant in a changing world is a challenge for us all.

The challenge for the Board is to build upon the success of IFRS Standards—one of the most successful standards in global finance. For us, that means improving the structure and quality of the financial statements and creating a better platform for broader developments in corporate reporting.

I’d also like to thank all of you for coming here. IFRS Standards are an example of what can be achieved when different stakeholders and countries work collaboratively towards a shared goal. Such international cooperation is in increasingly rare commodity these days. So I thank you for your continued support.

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