PRESENTING FINANCIAL PERFORMANCE – CHANGE ON THE HORIZON?

Regulators and standard-setters are thinking hard about alternative performance measures and further guidance via standard setting or regulation may not be comfortable for the preparer community. Peter Hogarth, a partner in PwC's Accounting Consulting Services, looks at recent developments.

The presentation of financial performance can be a battlefield where preparers of financial statements charge in to meet the regulators and standard-setters. Preparers, understandably, want to tell their story with a natural tendency to highlight the positive and pass quickly over any failures.

Regulators worry that the reader might be misled. Some regulators have responded by taking a hard line and imposing a standard format for the income statement with no additional sub-totals or analysis - a sort of uniform score card.

Elsewhere, creativity has flourished. Companies use columns, boxes, sub-totals and typeface to focus attention on 'underlying' or 'sustainable' earnings. This approach, the use of 'non-GAAP' measures, has its merits, but is not without its critics beyond the regulatory community.

How do the parties line up?

The standard setter

Hans Hoogervorst, IASB Chairman, said in a recent speech 'no single line can capture everything about a company's performance that a user will need'1. He was weighing in on the other comprehensive income versus net income debate.

The IASB is working on a broader project on disclosure. The tip of the iceberg will appear soon as an exposure draft on the first stage: narrow scope amendments on materiality, disaggregation of line items and order of notes. Much more will follow from the IASB on this topic.

Meanwhile, the European Securities and Markets Authority (ESMA) went to the IFRS IC with a question on non-GAAP measures. The IC did not enter the fray, declining the agenda request and booting the entire subject to the IASB. The IC did observe that IAS 1 not only permits flexibility in presentation but actually requires entities to present additional line items, headings and subtotals when relevant to an understanding of financial performance.

The regulators

ESMA has gone for a multi-pronged approach; publishing draft guidelines for listed companies that build on earlier recommendations from ESMA's predecessor body.

The UK's Financial Reporting Council ('FRC') is looking for merits on both sides of the debate. It recently reminded management of the need to improve the reporting of alternative performance measures and ensure consistency in their presentation. The FRC is not opposed in principle to non-GAAP measures but expects them to provide users with additional useful, relevant information. Recent enforcement actions have challenged the 'balance' of alternative measures as well as the consistency and clarity of disclosures around one-off or 'exceptional' items.

The Australian Securities & Investments Commission, however, has lined up for the uniform score card, making it clear that non-GAAP measures belong outside the financial statements altogether unless required by IFRS.

And everyone else?

Others have been weighing in. Few investors surveyed by PwC said they would ban non- GAAP measures but they would like some ground rules2.

A Standard & Poor's study highlighted that adjusted profit measures may often give investors a 'misleading impression of performance'3. Adjusted profit measures are seen to outnumber the unadjusted measures. S&P also commented on the frequently seen 'recurring' non-recurring charges. The International Federation of Accountants has just issued a consultation on the same topic.

What is next?

Non-GAAP measures are high on the agenda of regulators and standard setters. Users want to paint a picture of sustainable earnings, but will continue to question the preparation and balance of these measures. Will we see dramatic changes in current practice? The only 'highly probable' outcome is that the debate will rage on.

IFRS 3: RELEVANCE VERSUS COMPLEXITY – A DIFFICULT BALANCE

Olivier Schérer, PwC IFRS Technical leader in France, gives his view on the issues under discussion by the IASB as part of its Post-implementation review of IFRS 3 Business Combinations.

The IASB initiated a review of IFRS 3 based on how it has been applied in practice since implementation in 2010. The IASB has already identified 18 themes of concerns and is now asking for views from the IFRS community. I would like to comment on some of the issues.

Purchase of assets or business combination: the right question?

Many preparers have identified the difficulties in making this distinction. There is a perception that the guidance provided by IFRS 3 is not sufficient in some circumstances. But should it matter?

The distinction would not make a difference if the accounting principles for a purchase of assets and for a business combination were the same. But they are not. Some of the key differences relate to the recognition of goodwill, deferred taxes and acquisition-related costs. Looking at a recent example in the pharma industry, I would add to the list the accounting for contingent consideration, which, in this case, was the primary component of the purchase price.

Making the distinction matters when the impact of the accounting differences is material. But what is the real objective of the debate: is it to provide more guidance to facilitate the distinction, or is it to align the accounting?

I am concerned that providing more guidance will not address the real issue and will be an ongoing source of structuring opportunities. Aligning the accounting for purchase of assets and business combinations seems a more sensible approach. It would be an opportunity to reopen the debate around deferred taxes, so often misunderstood by the financial analysts, and to close the discussions relating to contingent consideration for separately acquired tangible and intangible assets.

Intangible assets and goodwill: does the complexity serve the relevance?

Many concerns are raised relating to:

  • the recognition of intangible assets versus goodwill;
  • the impairment test of goodwill versus amortisation; and
  • the full goodwill versus partial goodwill approach.

Intangible assets versus goodwill

Recognising intangible assets separately from goodwill is perceived as a 'compliance exercise' but does not reflect the approach taken by management when valuing the business as whole. Besides, the IASB has noted that the value attributed to those intangible assets is "strongly influenced by the accounting result that management seek"4.

Impairment of goodwill versus amortisation

IFRS currently does not allow amortisation of goodwill but requires an annual impairment test. We have all observed the complexity and judgments necessary for an impairment test, including the identification of the level at which goodwill is tested, the assessment of cash flows and its underlying assumptions. But there is also the assessment of whether internal reorganisations have sufficient substance to justify a reallocation of goodwill and the justification of sometimes significant differences between a fair value and value in use.

Mixed views are expressed on the amortisation approach and might also vary with the economic environment. Some of the merits of the amortisation of goodwill are (1) the lesser degree of complexity and subjectivity and (2) maybe a more accurate and relevant way to measure the return on capital employed.

Full goodwill versus partial goodwill

IFRS 3 allows a choice between recognising full goodwill (measured on a 100% basis like all other assets and liabilities) or partial goodwill (measured only for the portion acquired). This is different from US GAAP where only the full goodwill approach is accepted. The partial goodwill approach has merits because it does not artificially gross up the balance sheet. That said, it also creates many practical issues, especially relating to impairment tests after a change in parent's ownership interest.

These issues can hardly be addressed in isolation. One approach would be to eliminate the option for the partial goodwill approach, eliminate the requirement to recognise intangible assets separately from goodwill and require the amortisation of goodwill.

This practical approach would eliminate many of the complexities, increasing the consistency among IFRS preparers and the relevance of the income statement. It would also reduce opportunities for 'earnings management'. But this would be a departure from the recognition principles of intangible assets as per IAS 38.

Contingent consideration versus compensation expense: what does the expense reflect?

Many transactions include contingent payments to be paid to employees and/or former shareholders. IFRS 3 considers as a non-rebuttable presumption that payments contingent upon the employees remaining employed for a certain period of time are compensation expenses. This would include circumstances when such an amount appears disproportionate compared to the services rendered. This results in a portion of the purchase price, sometimes significant, to be expensed. The effects are that the consideration does not reflect the real cost of the transaction which then impairs the ability to measure the return on investment.

I believe such guidance should be turned into a rebuttable presumption which would allow, in some circumstances, both the contingent consideration and the compensation expense to be recognised separately at fair value. This would allow each component to be accounted for in a way that reflects its economic substance.

"As if" accounting: the disconnect between cash and the P&L?

IFRS3 has also introduced some counter-intuitive accounting for step acquisitions, loss of control and other changes in interest, for example:

  • step acquisitions (40% to 100% ownership): P&L impact for the fair value step up of the 40%, as if it had been sold
  • partial disposal without loss of control (100% to 80%): No P&L impact, as if it was as transaction with shareholders
  • loss of control (80% to 30%): P&L impact as if 80% had been sold, without 'recycling' through P&L the 20% previously sold.

No doubt there is some conceptual basis for this accounting, but does it really provide relevant information to the users and preparers as a measure of performance? When I hear financial analysts saying that they ignore those impacts, I have my answer.

Let's be positive: the IASB has identified the issues well. But let's also be realistic: some are more complex than others to address as the 'wish list' touches some of the fundamental concepts of IFRS 3 and other Standards. This will be for the IASB a delicate navigation where the ultimate objective should be relevance and simplicity.

This article represents the individual view of the author.

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Footnotes

1. 05 February 2014 Hans Hoogervorst, Chairman of the IASB, 'Defining Profit or Loss and OCI... can it be done?' speech to Accounting Standards Board of Japan

2. December 2007, Performance statement - Coming together to shape the future

3. 18 February 2014, Standard and Poor's Ratings Direct - Why Inconsistent Reporting Of Exceptional Items Can Cloud Underlying Profitability At Nonfinancial FTSE 100 Companies

4. November 2013 IASB Meeting, Agenda paper 13A, IFRS 3 Business Combinations— Input obtained from Phase I of the PiR

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.