PwC IFRS blog

Holiday reading: The book you can’t put down

Here in the northern hemisphere we are now well into summer, and many of you may be looking forward to a well-earned holiday. If you cannot quite get into the holiday mood and are still thinking of what to pack as holiday reading, the IASB has provided us with a few options.

A few weeks ago, I commented on the IASB’s proposals for the future of accounting for financial instruments. Progress has been rapid, and in July it published an exposure draft proposing a fundamentally new model for classifying and measuring financial instruments.

The IASB is proposing that financial instruments should be classified into two measurement categories: fair value and amortised cost. The amortised cost category would be available for financial instruments meeting both of the following criteria:

• they contain only basic loan features; and
• they are managed on a contractual yield basis.

All other financial instruments would be measured at fair value with gains and losses recognised in profit or loss (although an irrevocable election to recognise gains and losses in equity would be available for equity investments that are not held for trading). There are also proposals to change radically the treatment of embedded derivatives.

IAS 39 needs to be simplified, and this clearly seems to be a step in the right direction. It is also good to see the continuation of a ‘mixed measurement model’ and some focus on a company’s business model in determining classification. Nevertheless, the proposed changes are fundamental and are likely to have far-reaching implications for companies with significant portfolios of financial instruments, particularly for those in the financial services sector. The proposals are likely to result in reclassifications between measurement categories in both directions: from amortised cost to fair value and from fair value to amortised cost. The extent of any net impact on the income statement will depend largely on the complexity of the financial instruments that a company holds and the way in which they are managed.   

The comment period is short - comments are due by 14 September. This may seem too tight for such an important project but is inevitable if the IASB is to issue a new standard that can be available for use by the end of the year, as requested by the G20 leaders and, more recently, European finance ministers (mandatory adoption seems likely to be deferred to 2012).

But this is not all the summer reading that the IASB has provided. In June, it issued a discussion paper on the subject of credit risk in liability measurement and a ‘request for information’ on the feasibility of an expected loss model for impairment of financial assets. Comments on both papers are requested by 1 September, and the former will be relevant for the future debate of the proposals contained in the classification and measurement exposure draft. On impairment, an exposure draft is expected in October.

These are important proposals that will have an impact on most companies. Naturally, PwC will be considering the proposals carefully, placing particular emphasis on the practicality of their implementation, especially by those who wish to adopt the final classification and measurement standard straight away. And it is vital that others comment too. Maybe this is one holiday read that you can’t afford to miss.

As always, I would be interested in your thoughts, either by commenting here or by email.

A sense of context

If I was to report that my company’s net income for 2008 was 100, it would not tell you very much. If I add that net income has increased by 3%, you start to learn a little more. If I now give you a complete set of financial statements, you will have a clearer picture of my company’s performance and financial position. But is that all you need? Do you know anything about my company’s strategy, the risks it faces, the resources at its disposal?

Companies in some parts of the world provide a supplementary narrative report (for example, ‘management’s discussion and analysis’ or ‘operating and financial review’). The nature and scope of these has largely been a matter for governments and securities regulators. But last month the IASB published its own draft guidance for management commentary.

It is proposing that the information to be included should present management’s view on not only what has happened during the period, but also why management believed that it happened and what the implications might be for the company’s future. Specifically, it proposes that the management commentary should accompany the financial statements and should include information about the nature of the business; its objectives and strategies; its resources, risks and relationships; its results and prospects; and the critical performance measures used by management. This looks straightforward and uncontroversial.

An international PricewaterhouseCoopers survey of investors and analysts in 2007 (Corporate reporting: Is it what investment professionals expect?) revealed little investor demand for prescriptive standards on narrative reporting. Here again, the IASB is not being controversial as the proposed guidance would not be mandatory. This is not to say that information about markets, strategies and value-creation isn’t important. On the contrary, investors and analysts consider it critical. However, narrative reporting in annual reports was seen by some respondents to the survey as more of a public relations tool than a source of information that helps to place the financial statements in context. One exception was when talking to specialists in industries that use established metrics to assess performance. For example, retail analysts were interested in same-store sales or sales per square foot, and telecoms analysts wanted to know about average revenue per user.

Of course, alternative measures of performance attract strong opinions both in favour and against. The US SEC generally discourages or prohibits adjusted earnings measures, particularly on the face of the income statement; in the Netherlands, both the stock exchange regulator and Institute for Public Auditors have opposed the use of measures like EBITDA. On the other hand, in France, the local standard setter has recommended separate reporting of certain line items and sub-totals in income statements, while in the UK alternative performance measures are accepted provided they are explained and the GAAP information is given equal prominence. This approach is broadly in line with the 2005 recommendation of the Committee of European Securities Regulators.

The management commentary proposals and IFRSs themselves seem to be aligning more with the information used by management to run the business. IFRS 7 requires financial risk disclosure based on information provided internally to key management personnel. Segment analysis under IFRS 8 is driven by information used by the chief operating decision-maker. And the recent discussion paper on financial statement presentation refers to a ‘management approach’ to classifying items in the financial statements. At a conceptual level, there is a lot to be said for aligning external reporting with information actually used to manage the business.

Where alternative performance measures are presented, the IASB draft proposes that this fact should be disclosed. Importantly, the measures should then be defined, explained and reconciled to the financial statements – a proposal not unlike some existing practices.

Does all of this mean that alternative measures of earnings might be gaining more widespread acceptance, at least at the IASB? Might the management commentary become the natural home for alternative performance measures? Used responsibly and consistently, and properly explained, such measures can add a great deal of colour and aid understanding when presented alongside financial statements. The key is to understand what has been included or left out and why, and to be presented with the data in a readily accessible and comprehensible manner. Surely even the strictest of regulators would agree with this approach in principle. 

I would be interested in your thoughts, either by commenting here or by email.