A European example of issues arising in presenting operating measures in the income statement
Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA) (for more background see here); this is from their 22nd edition:
- The issuer uses the revaluation model in IAS 16 Property, Plant and Equipment for its vessels.
- In 2015, the fair value of the vessels decreased and the issuer was required to recognize a revaluation loss. In the consolidated income statement the issuer presented this revaluation loss as a separate line item after the ‘net result’.
- The enforcer did not agree with this presentation. The issuer should have presented the revaluation loss within its operating activities.
- The revaluation loss of an asset that is being used in the issuer’s operations is an operating item in nature. As set out in paragraph BC 56 of IAS 1, it would be misleading if items of an operating nature were excluded from the results of operating activities. Consequently, the revaluation loss should not have been presented as a separate line after net result.
That’s the entire description of the issue and its resolution, certainly among the briefest in any of ESMA’s summaries, and therefore suggesting that the conclusion is unusually self-evident. But I expect many readers will intuitively regard the kind of revaluation losses described as the very epitome of something to be shoved below some kind of subtotal. Among other things, preparers might argue that such valuation-driven items will fluctuate in a way that doesn’t help in anticipating future cash flows, operating margins, or other core performance measures.
The cited paragraph IAS 1.BC56 does indeed say that in the IASB’s view: “it would be misleading and would impair the comparability of financial statements if items of an operating nature were excluded from the results of operating activities, even if that had been industry practice.” Note though that it doesn’t preclude excluding some such items from any kind of income statement subtotal, only from a subtotal representing “results of operating activities.” While the standard says that “it would be inappropriate to exclude items (i.e. from the results of operating activities) on the grounds that they do not involve cash flows such as depreciation and amortization expenses,” it’s obviously not uncommon under IFRS to report an EBITDA-type line item which does exclude such items. In contrast, the ESMA example talks only about excluding the items from the “net result,” without clarifying what that means. To many of us, “net result” probably sounds more like an all-in bottom-line measure than a pure operating activities measure, but for the sake of moving on, we’ll assume ESMA means it as the latter.
The key building block of the rationale is the first sentence: “The revaluation loss of an asset that is being used in the issuer’s operations is an operating item in nature.” Whereas the depreciation charge on a cost-method asset reflects a measure of economic benefits consumed during the period, a carrying value adjustment arising from a revaluation (of a property, for instance) might seem more susceptible to being affected by external factors not directly relating to a particular period’s operations. We should recall though (it’s easy to forget, as so few of us ever have to deal with the revaluation model in practice) that revaluation gains are generally recognized in other comprehensive income rather than in profit or loss; they’re only recognized in net income to the extent that they reverse a previous charge arising from a devaluation of the same asset. Presumably a revaluation loss recognized in profit or loss will usually speak in some way at least to a decline in the anticipated economic benefits arising from the underlying asset. So ESMA’s assertion doesn’t seem broadly unreasonable. But as a technical matter, I don’t know that it can be stated quite as boldly as ESMA states it.
Anyway, this general topic might be in play as the IASB continues to discuss elements of its “principles of disclosure” project. A recent staff paper summarizing some of the feedback to the Principles of Disclosure discussion paper notes that “some respondents—including many of the Japanese respondents—suggested the Board should focus on requiring and defining an ‘operating profit’ subtotal” (instead of EBIT or EBITDA). The May 2018 IASB Update records some discussions relating to presenting a subtotal for “profit from continuing operations” – however this would simply represent (as the accompanying agenda paper clarifies) “a subtotal before discontinued operations” – that is, a subtotal encompassing everything else that’s not being discontinued. It follows then that a subtotal for “profit from continuing operations” might reflect some items that are excluded from “results of operating activities.” That distinction might make sense in a narrow technical sense, but how would it help general readers to use such similar terminology for two potentially quite different performance measures?
So while the ESMA example is too narrow to be of huge applicability in itself, it does encapsulate the ongoing definitional problems and conceptual murkiness that continue to mark this area of financial reporting, and probably will for some time yet…
The opinions expressed are solely those of the author