In line with statements that preceded the publication of the IFRS 18 and its accompanying explanatory notes, operating profit was the critical trigger for issuing the new standard. Yet paradoxically, the operating category — whose items collectively constitute operating profit — is the only category defined residually, as a default. This residual definition serves as a wide-open back door, permitting (and indeed requiring) the inclusion of income and expenses entirely unrelated to operating activities, such as investment property maintenance costs, credit facility commitment fees, and government grant income. In certain hedging transactions, classification may even be contingent on formal documentation and consequently could be subject to manipulation. To avoid misleading investors regarding the most important category in the new income statement, an independent definition of the operating category should be established.
In approximately six months, IFRS 18 will become mandatory — a standard that introduces a highly warranted transformation in the income statement by dividing profit or loss into three primary categories: operating, investing, and financing. While this represents a most significant shift in how investors view financial performance, the implementation preparations currently underway highlight flaws arising from the IASB’s decision not to define the operating category independently, but rather to treat it as a residual category — providing independent definitions only for the investing and financing categories.
The Basis for Conclusions accompanying the new standard notes that an independent definition of the operating category was considered, but ultimately rejected, primarily due to cost-benefit considerations and concern over comparability impairment resulting from the exercise of judgment in borderline cases.
Background
The definitions of the investing and financing categories are generally based on the relevant item in the statement of financial position: where an item is investment-related, income and expenses arising from it are classified in the investing category (e.g., an investment in a financial asset); where an item is financing-related, income and expenses are classified in the financing category (e.g., interest on a loan). In addition, income and expense items eligible for classification in the investing and financing categories are included in an exhaustive list — so an item that is left outside that list falls into the residual operating category by default.
Distortions Arising from the Residual Approach
A basic example of the distortion resulting from the residual definition of the operating category is investment property maintenance costs incurred by a company whose main business activity is not property investment. An investor would clearly expect maintenance costs to be factored in as an integral component of the calculation of the return from the income-generating asset. Yet while rental income is classified in the investing category, maintenance costs on that same property default into the operating category. This occurs because the investing category — being positively defined — comprises an exhaustive list of eligible items, which includes only income (not expenses) generated by the investment property, along with fair value gains and losses on its remeasurement. To illustrate the distortion, if rental income is relatively low and maintenance costs are substantial, the default classification leads to a situation where the investing category reports a profit, while the property actually generates a net loss — concealed within the operating category.
A further example of distortion relates to loan commitment fees on revolving credit facilities, or facilities where drawdown is not expected, which are classified in the operating category on the grounds that no liability exists. This is even though the purpose of such fees is unequivocally to secure financing capacity — making them a clear financing activity that belongs in the financing category.
Beyond the above examples, the classification mechanism generates additional material distortions capable of significantly misrepresenting operating results. For instance, for a subsidiary that consists primarily of “investment assets”, the new standard requires an operating category classification for a bargain purchase gain on acquisition as well as a gain on disposal, only because the subsidiary also has a single “operating asset”.
Similarly, foreign exchange differences and changes in the fair value of derivatives that cannot be attributed to specific items, will also be classified — by virtue of the residual definition — in the operating category.
An Arbitrary Determination
Two classification issues recently published by the IFRS Interpretations Committee (IFRIC) further highlight the significant problems inherent in the existing classification mechanism and the resulting impairment of comparability.
The first case concerns a recent IFRIC agenda decision, according to which the formal manner in which risk management is defined ostensibly leads to different accounting treatment, despite identical economic substance. To illustrate, consider a company with a Euro functional currency holding a financial asset of $100 and a financial liability of $120. The company enters into a currency swap derivative for the net exposure of $20 to hedge its currency risk without applying hedge accounting. If risk management is defined on a gross basis — meaning management documents foreign currency risk for both the asset and the liability — the managed risks affect more than one category (investing and financing), but grossing up the net currency swap is not permitted, and so the gain or loss on the derivative consequently defaults into the operating category. Conversely, if risk is managed on a net basis, meaning management documents foreign currency risk only for the net liability balance ($20), the managed risk affects only one category (financing), and the gain or loss on the derivative is classified in the financing category.
This situation is deeply problematic and adds to a series of issues arising from the residual definition of the operating category in the new standard.
The second problematic case published by the IFRIC concerns exchange differences arising on an intragroup balance that is eliminated on consolidation. In such circumstances, the IFRIC permits an accounting policy choice of classifying such exchange differences in the operating category by default — even where it is clear that those exchange differences did not arise from operating items and bear no relation to operating activities.
A further distortion concerns government grants presented on a gross basis as a liability in the statement of financial position (deferred income) and as income in the statement of profit or loss (rather than as a deduction from the related expense). Where a grant is intended to compensate for the cost of a clearly “investment-related” asset (such as investment property) or a clearly “financing-related” item (such as interest on a bank loan), the appropriate classification of grant income should follow the classification of the item whose cost the grant is intended to compensate. However, because the grant income arises from the “release” of the deferred income liability, and that liability does not involve only the raising of finance, the standard precludes the possibility of classifying such income in the financing or investing category. Accordingly, the income defaults into the operating category, in a manner that contradicts the purpose of the grant and its economic substance.
Proposed Solution
In conclusion, this situation could lead to material distortions in the presentation of operating results — the most significant category in the income statement — thereby misleading investors. While comparability among reporting entities is an important qualitative characteristic, it is not the sole consideration. When comparability leads to the classification of items in the operating category despite having clear investing or financing characteristics, the resulting distortions can create a dual effect, impacting both the operating category (and operating profit), which absorbs these items by default, and the investing or financing category, which is presented without items that rightfully should be included.
The proposed solution is the elimination of the default classification into the operating category — through the establishment of an independent definition of this category. For items that are not classified directly into any of the defined categories, management should be permitted to exercise judgment, subject to consistent accounting policy — or alternatively, an additional “other/miscellaneous” category should be established.
(*) Written by Shlomi Shuv