In this spotlight article, we highlight essential aspects of the new classification, presentation and disclosure requirements for financial instruments issued by companies proposed in the recently published Discussion Paper. We expect that investors will find the results of the proposals useful when analysing companies that issue financial instruments that have characteristics of both liabilities and equity.
Investors analyse the financial performance and financial position of companies to assess the expected risks and returns from owning company-issued financial instruments. To that end, investors analyse a company's liquidity and cash flows position (i.e. will it have the economic resources to meet its obligations as and when they fall due?) and balance-sheet solvency and return (i.e. does it have sufficient economic resources to meet its obligations at a point in time and has it produced a sufficient return to satisfy an obligatory return?). An IFRS Standard that facilitates analysis of this information is IAS 32 Financial Instruments: Presentation.
IAS 32 works well for most financial instruments. However, financial innovation has resulted in a growing number of complex financial instruments that combine features of both liabilities and equity, making it challenging for companies to apply IAS 32. Investors have been voicing their concerns about the limited information they get about these types of instruments. The European Securities Markets Authority (ESMA) has highlighted instances1 where companies provide inadequate disclosure of the analysis behind their classification of an instrument as equity or liability, of key instrument characteristics, and of accounting policies in cases where IAS 32 requirements are challenging to apply in reaching a classification decision. Although the ESMA examples are not fully representative of the challenges of IAS 32 or the rationale for the International Accounting Standards Board (Board) to pursue this project, they offer insights into the issues investors face.
The Board has responded to the conceptual and application challenges identified in IAS 32 with a preferred approach that is coherent and complete, while limiting changes to classification outcomes for most of the financial instruments that are well understood today. The Board believes the preferred approach will result in more consistent classification of issued financial instruments and enhanced comparability between companies. The Board is also proposing additional presentation and disclosure requirements to provide more meaningful information to investors.
The existing presentation of gains or losses in profit or loss (P & L) resulting from changes in the fair value of financial liabilities with equity-like returns (e.g. shares redeemable in cash at the fair value of the ordinary shares) may appear counter-intuitive. Gains are recognised when the company performs poorly—i.e. the fair value of the financial liability falls. The resulting P & L volatility creates noise unrelated to business performance.
The proposed presentation change will require such changes to be reported in Other Comprehensive Income (OCI) and not subsequently reclassified to P & L.
Similarly, the balance sheet presentation for such instruments under the preferred approach will require companies to present the carrying amounts of these instruments separately from other financial liabilities.
Investors have been calling for better information about equity instruments. This includes information about claims that participate in the upside potential of a company's economic resources and the effects that different features of equity instruments have on the distribution of returns between those instruments.
The Board is proposing expanding the attribution of total comprehensive income to all equity instruments (regardless of whether those equity instruments are dilutive or not at the reporting date). Under current requirements, the attribution of total comprehensive income to ordinary shareholders includes profits and OCI that may belong to other equity holders (e.g. holder of unexercised warrants). Similarly, when companies present dividends paid or declared to shareholders, it isn't clear whether the amounts include dividends paid or declared to holders of other non-derivative equity instruments (e.g. preference shareholders). The Board's proposal for attribution would provide insights into how the company's total comprehensive income is shared among types of equity instrument holders.
Investors want to understand the dilutive effects from all financial instruments that may entitle its holder to ordinary shares. Such information helps investors understand how the company has financed its operations in the past and how the company's capital structure might change in the future. Information is often missing under current requirements as the Diluted EPS calculation excludes antidilutive instruments. The Discussion Paper proposes requiring companies to disclose in the notes to the financial statements a list of all financial instruments that could dilute the ordinary shares and disclose the maximum number of additional potential ordinary shares that the entity may be required to issue.
Additionally, the Discussion Paper proposes requiring disclosure of the priority of financial liabilities and equity instruments upon liquidation, and the terms and conditions of financial liabilities and equity instruments that affect the amount and timing of cash flows.
Overall, the proposed new package of disclosure requirements will help investors better understand the risks and rewards from owning financial instruments issued by companies.
1. ESMA (Enforcement and Regulatory Activities of Accounting Enforcers 2017)
In this spotlight article, we report on the implementation of IFRS 15 and IFRS 9. We also highlight the most common disclosures provided by corporates and banks from the first-time adoption of these new Standards.
IFRS 15 Revenue from Contracts with Customers and IFRS 9 Financial Instruments represent big changes to revenue and financial-instruments accounting. These Standards were developed to enhance comparability and consistency in financial reporting. More than half a year into their application (both Standards are in effect from 1 January 2018), we highlight some benefits and some new disclosures observed from companies applying these Standards.
IFRS 15 replaces IAS 11 Construction Contracts and IAS 18 Revenue, providing a comprehensive principles-based framework for revenue recognition and measurement. The new Standard includes enhanced guidance on how to deal with specific issues such as identifying the separate components of a contract (performance obligations), overtime versus point-in-time revenue recognition, measuring revenue, principal versus agent determination, revenue in licensing transactions, and contract modifications. The previous requirements offered limited guidance on these issues and companies often adopted distinct policies, which led to a lack of comparability or consistency.
In another area of improvement, IFRS 15 also provides guidance on contract costs that must be capitalised. These requirements limit the creation of company-specific cost capitalisation policies to report on assets on the balance sheet that are outside the scope of Standards on inventory, fixed plant, property and equipment (PP&E) and on intangible assets. Ultimately, we believe that investors can expect to see revenue recognised and measured in a more consistent and rigorous manner by companies that file reports using IFRS Standards.
IFRS 9 replaces IAS 39 Financial Instruments: Recognition and Measurement, most notably, introducing a new financial asset impairment model (expected credit loss approach, or ECL). Banks in various jurisdictions applied IAS 39 according to the jurisdiction's banking regulations, with some jurisdictions applying a more expectational approach to loan loss accounting than others. In contrast, IFRS 9 provides a uniform expectational framework for loan loss accounting that will enhance comparability between banks.
We examined the transition and implementation disclosures of ten corporates in Canada, Europe, Taiwan and the UK that applied IFRS 15 for the first time. The fact-finding exercise focused on sectors we understood to have the greatest potential to see an impact from the implementation of IFRS 15, including telco, software, IT and services, aerospace and defence, real estate, and construction and engineering.
All corporates in our sample provided information on how IFRS 15 concepts will be applied to their contracts and information about the impact to shareholders' equity of first-time application (FTA). All telcos in our sample reported a gain to equity on FTA from the restatement of the prior years' net profit, largely driven by the impact of the new requirements on the accounting for bundled mobile contracts. In contrast, both aerospace and defence companies reported a loss to equity on FTA because of reversal of smoothed contract margins executed in prior years (under the previous requirements). The impact to equity for companies in other sectors was more mixed.
In the context of timing and measurement of revenue, a gain to equity on FTA can signal that under the previous requirements a company recognised lesser amounts for goods and services delivered to the customer in the earlier part of the contract life (for example in a bundled mobile contract, the mobile handset was allocated a smaller portion of the contract value), or, revenue recognition was delayed to later in the contract life (e.g. some progress on a construction contract was reported as work-in-progress in inventories even though control had been transferred to the customer). Conversely, a loss to equity on FTA can signal that under the previous requirements companies accelerated the recognition of revenue as compared to revenue recognition under IFRS 15.
We examined the quarterly or interim reports of companies for IFRS 15 disclosures required by local securities markets regulation or IAS 34 Interim Financial Reporting requirements. Although IFRS 15 disclosure requirements apply to annual accounts, we observed that many companies disclosed information about the use of judgements and contract assets (required by IAS 34), when they disaggregated revenue. Our expectations on the quality of revenue disclosures that will be produced in the 2018 annual accounts have been bolstered after seeing numerous examples of useful disaggregation of revenue information provided by companies.
We examined the transition and implementation disclosures of seven of the largest banks that applied IFRS 9 for the first time, from Germany, Sweden, Canada and the UK. All UK banks in our sample published separate transition reports while banks in the other countries incorporated transition information into their quarterly or interim results. Broadly, we have not observed any major surprises in the transition impact to equity (from the application of the new asset impairment model) for the banks in this limited sample. The consistency between reports before and after IFRS 9 may be partly attributed to the more benign macro environment observed at the time of transition than at previous times.
Most banks provided detailed transitional disclosures in the following areas, however the comprehensiveness of the disclosures vary:
We examined the Q1 or H1 2018 results of these banks for IFRS 9 disclosures related to ECL, including breakdowns by stages, transfers and information about the gross loan book. All banks in our sample provided reconciliation tables with varying transparency and detail. For instance, some bank disclosures were more helpful for investment analysis than others, with reconciliation tables depicting information about transfers between stages and the impact of net new originations on both allowances and gross loans. Similarly, some banks provided a reconciliation of the ECL movement to the P&L provision charge for the period.
As banks continue to refine their approaches towards high quality implementation of IFRS 9, we would encourage investors to be proactive and recommend that their management teams provide more meaningful information in their disclosures.
The Board sets Standards to help you, the investor, make decisions about companies. But we can't do it without your views. Your participation helps us understand whether potential changes to the Standards will provide you with the information necessary for investment analysis.
Below are some of the projects that we expect to engage with investors on during 2018.
For a full list of topics please visit the work plan.
In June 2018, the Board published a Discussion Paper setting out the Board's 'preferred approach''' to improve the information that companies provide in their financial statements about financial instruments they have issued.
The Board's preferred approach seeks to:
A brief overview of the Discussion Paper can be found in the Spotlight article above, and a Snapshot document is available here.
The Management Commentary Consultative Group, whose aim is to advise the Board in developing proposals for updating IFRS Practice Statement 1 Management Commentary, held its first meeting on 28 September 2018. The group, which draws members from different stakeholder groups including investors and analysts, discussed:
The work of the consultative group will be supplemented by a wider outreach program with a broad group of stakeholders, including investors and analysts.
Further information on the project and the papers for this meeting can be found here.
Erkki Liikanen appointed as Chair of the IFRS Foundation Trustees
Former Governor of the Finnish Central Bank Erkki Liikanen has been appointed as the Chair of the IFRS Foundation Trustees. He succeeds Michel Prada, who has served as Chair since 2011.
The Board announced the composition of its Management Commentary Consultative Group
The Board announced the membership of its Management Commentary Consultative Group, established to advise the Board as it develops proposals for updating its guidance on management commentary in financial reports. The full composition of the group and details of its meetings can be found here.
The IFRS Foundation has moved
After being based at 30 Cannon Street in London for 17 years, the IFRS Foundation—including the Board—relocated to Canary Wharf in August 2018.
We are delighted to support IOSCO's World Investor Week programme
The programme's focus on investor protection and investor education resonates strongly with our own work—to develop IFRS Standards that bring transparency, accountability and efficiency to the financial markets around the world.'
Chairman's speech: Japan and IFRS Standards
Chair of the IASB Hans Hoogervorst spoke at an event hosted by the Accounting Standards Board of Japan about adoption of IFRS Standards around the world and the Board's work on Goodwill and Better Communication.
In this series of web presentations, the Board Technical Director Kumar Dasgupta and Technical Manager Uni Choi cover different chapters of the Discussion Paper Financial Instruments with Characteristics of Equity that was published in June 2018 to help stakeholders as they prepare to submit their comments.
Click below to access webcasts on:
This webcast provides an overview of the effect of participation and other features on the measurement of the fulfilment cash flows and the contractual service margin. It is part of a series that the Board is providing to support the implementation of IFRS 17.
As part of our activities to support the implementation of IFRS 17 Insurance Contracts, we published educational materials for:
Gary Kabureck outlines similarities between the measurement of obligations at current value and the recognition of revenue as a company provides services to its customers in IFRS Standards.
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