Graham Holt explains the changes to financial statements that the IASB and the FASB are proposing, and reviews the possible pitfalls that preparers could encounter
This article was first published in the February 2011 edition of Accounting and Business magazine.
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In July 2010, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) published a staff exposure draft that proposes changes to the presentation of financial statements under International Financial Reporting Standards (IFRS).
The boards believe the revised format will give users a better understanding of a company's performance by subdividing financial position, comprehensive income and cashflows into core operations and other activities.
The publication of the official exposure draft has been delayed until 2011. The boards' plan is to consult with stakeholders and look at the cost benefits of the change and the implications for financial institutions. Only then will the boards consider whether to change any of their tentative decisions.
The key changes proposed are:
- Assets, liabilities, revenues and expenses will be categorised under operating, investing and financing, with separate sections for taxes and discontinued operations.
- The statement of cashflows will be prepared under the direct method, with certain indirect information also presented on the face.
- There will be a 'roll-forward' presentation in the notes for significant line items in the statement of financial position.
- Information will be disaggregated by function (for example, the cost of sales, selling and marketing) in the statement of comprehensive income; and by nature (for example, bad debt, advertising) in the notes.
- Extensive segment disclosures will be made in the notes for the FASB constituents.
The boards' aim is to address concerns that the current rules permit too many alternative presentations and that information in financial statements is confusingly aggregated and inconsistently presented, making it difficult to fully understand the relationship between an entity's financial statements and its financial results. The primary financial statements would be organised around an entity's business activities and separately from its financing activities. Business activities would further distinguish operating activities from investing activities, while financing activities would be separated into debt and equity categories.
An entity would also present separate sections for discontinued operations, income taxes and multi-category transactions. The proposed new categories for the statements of financial position and comprehensive income are shown in the tables below.
New categories for the statement of financial position
Financing arising from operating activities
- Discontinued operations
- Income taxes
- Total assets
- Total liabilities
New categories for the statement of comprehensive income
Financing arising from operating activities
- Total operating income
- Total business income
- Income taxes
- Net operating from continuing operations
- Discontinued operations
- Net income
- Other comprehensive income
- Total other comprehensive income
Information would be disaggregated by function in the primary financial statements and by nature in the footnotes. 'Function' refers to an entity's primary activities (for example, the sale of goods or services); 'nature' refers to the economic characteristics that distinguish assets, liabilities, income and expenses (for example, the nature of expenses includes labour and materials).
The proposed standard is based on two core principles: cohesiveness and disaggregation, which the boards believe will aid understanding of the reporting entity's financial information.
Cohesiveness focuses on the relationship between items in the financial statements by consistently linking transactions across statements. For example, while interest is currently reported in current liabilities as a finance cost and as an operating cashflow, in the new presentation it would be consistently reported in the debt category of the financing section across the financial statements.
The aim of disaggregation is to provide enough detail to make clear what the entity's activities and cashflows are, and to ensure that the relationships between assets or liabilities (and the effects of changes in those assets or liabilities) are consistently reflected in the financial statements.
If the economic characteristics of transactions are dissimilar, then separate presentation is required. For example, labour and materials are likely to have different economic characteristics, and so may be presented on a disaggregated basis.
The disaggregation and cohesiveness principles do not apply to the statement of changes in equity.
Accordingly there are common sections and categories in which a reporting entity will classify financial information. An entity will classify items in its financial statements based on how those items relate to its activities across the financial statements. The classification of items could differ based on the sector in which the reporting entity operates.
The structure and appearance of the statement of financial position would change significantly. However, in addition to the subtotals required for each new section, some required subtotals in the statement of financial position, such as total assets and liabilities, would continue to be presented.
Cash would always be classified in the operating category of the business section with the result that cash equivalents will be included in the investing category for most commercial entities.
The proposal no longer allows an entity to treat an operating cycle as longer than 12 months, because an asset or liability would be classified as short term if the shorter of its contractual maturity or its expected date of realisation were within one year of the reporting date.
An entity could present the statement of financial position in order of liquidity within each section and category, rather than classified as short and long term, if the information were considered more useful. This may be the case for financial institutions.
The boards propose to eliminate the option of presenting comprehensive income in two statements, and will require a single, continuous statement of comprehensive income with two distinct sections for profit or loss and other comprehensive income.
As explained above, entities will generally disaggregate income and expense by function and further disaggregate income and expense by nature.
However, if an entity does not consider disaggregation by function to be useful to users, it may disaggregate its income and expense items by nature in the statement of comprehensive income only.
This model will significantly increase the amount of information to be disclosed and so could require changes in systems to capture the information.
Statement of cashflows
The boards have tentatively concluded that cashflows should be presented using the direct method and that a reconciliation from operating income to net cash from operating activities (that is, an indirect reconciliation) should also be presented.
The direct method requires the presentation of gross cash receipts and cash payments classified in the same section and category as the related asset, liability or equity item in the statement of financial position, and the related income or expense item in the statement of comprehensive income.
The boards believe the direct method cashflow statement, together with the indirect reconciliation, provides more transparent and useful cashflow data. It is suggested that cashflow information provided by the direct method could be prepared using information directly from the accounting records or by being derived from changes in assets and liabilities.
Most entities currently use the indirect method, so this requirement would mean changes to systems to collect the information. For example, an entity would have to collect information relating to accounts payable for direct materials and labour to determine cash paid.
The draft includes a proposal that all companies (except non-public entities) provide a roll-forward presentation of changes in significant assets and liabilities.
This presentation would include an analysis and explanation of the nature of transactions and remeasurements that caused the changes in the account balances.
The reconciliation requires a roll-forward of the start and end balances of the asset or liability, separately presenting the effect of changes resulting from such things as cash inflows and cash outflows, non-cash transactions that are recurring and routine, accounting allocations such as depreciation expense, write-downs or impairment losses, and remeasurements.
The IASB has tentatively concluded that all companies should present, in a single note, the changes in each item of debt, cash, short-term investments and finance leases. The staff draft does not define net debt explicitly but requires presentation of the information needed to determine net debt in a single note.
It is evident that financial statements will be presented differently under the new proposals and more disaggregated information will be required.
Users of financial information may find that the enhanced cohesiveness and disaggregation gives them a better insight into entities' financial position and performance. However, preparers will encounter costs and system challenges, and may feel the increased disclosure is counter-productive.
The move to IFRS has brought a degree of consistency to corporate reporting but there may be some sacrifice of comparability between entities if the principles of the staff draft are carried forward into the final standard.
Graham Holt is an examiner for ACCA and executive head of the accounting and finance division at Manchester Metropolitan University Business School