Way of disclosure in Principles-based Standards

Transcription

1 Way of disclosure in Principles-based Standards How operating activities (Main business)should be presented 10 th IFRS Digital reporting Workshop Date and time:6 February 2017, 18:30-20:30 (Tokyo time) Venue: IFRS Foundation Asia Oceania office

2 Back ground (the reason why we chose this theme) Primary Financial Statements project at IASB is considering to improve the problem of companies presenting different subtotals in PL since there is no definition of such subtotals. Some investors have expressed the following views (1) Having different subtotals for each company is certainly misleading, having definition is preferable. (2) When requiring Operating profit subtotal, you need to define operating first. (3) Current PL is not sufficient to take out necessary information to estimate corporate future value. Instead we use CF or BS to classify certain items. (4) One of the solutions might be to align classification in PL and CF, or make more detailed classification on BS. It is difficult to solve these issues, but isn t there an answer in principles-based accounting standard? This time, we decided to discuss whether a PL item is operating or investing. Number of attendees Categories Participants overseas 44 attendees from Japan (1 via phone), 5 from London 10 Investors, 11 Media and Information provider(includes researchers), 7 CPA, 3 Regulator/Stock Exchange, 6 Prepares (includes support service), 3 Sell-side, 1 Academic Regulator, Standard-setters, Stock exchanges, etc. joined from UK, France, HK, Malaysia, Indonesia, Vietnam, Philippines 1

3 Comments (for this workshop) from Foreign investors (1) Comment from a Rating company in London We have devised our own way of defining what is operating or not (in order to seek to put all companies on an even footing when calculating metrics such as EBITDA, for example). In simple terms we look to the cash flow statement classification to guide us as to whether a transaction is operating or not (which is turn is driven by whether a long-term asset has been purchased/created/disposed). As an example - some companies present gains/losses on the sale of a business or PPE as part of operating profit, but we view the gains/losses as non-operating items because the cash flows are shown as investing. Meanwhile, restructuring costs are operating item as the cash flows are operating. This simple approach is not perfect, but works well as a guide in normalizing metrics (2) Member of CFA UK Financial Reporting Analysis Committee, (Quoted from article on IASB project) IASB has embarked on a project called Better Communication in Primary Financial Statements and hooray the definition of profits (or losses) is at the heart of it. Evidence of the problem is ubiquitous. Some companies break down operating expenses, others do not, so even the key operating profit number used for margin and interest cover calculations is neither defined nor comparable. Then there are the adjustments. The one generalisation that can be made is that costs and losses are far more likely to be counted out than profits/gains. Beyond that even peer companies make different decisions about whether to count in such costs as amortisation of intangibles, restructuring and litigation. To make sense of this for forecasting purposes and to compare companies, financial analysts and data aggregators make their own adjustments. So the IASB has at last grasped the nettle and is considering requiring and defining certain profit sub-totals. At the same time, it is not likely to ban other numbers, so managements can still slot their view of what is important between the standardised lines. But highlighting the more idiosyncratic approaches should discourage them, as well as providing an antidote to adjusted numbers being used for bonus purposes. Operating profit is not the same as earnings before interest and tax (EBIT), which includes non-operating income and expense. But I am not so sure about standardising recurring operating profit. This is one of the options the IASB is exploring as it listens to the siren voice of current practice. The search for recurring, sustainable, core or underlying profits is not just a management game but one that analysts play as they seek a baseline for forecasts. The models work better if the inputs are not volatile; life would be so lifemuch easier in a smooth, predictable world. But that is not economic reality and most business profits do not look like annuities. It is important that this accounting exercise restores discipline. Costs that some companies count out, such as share-based payments to employees, are clearly operating costs (workers would want more pay in their absence). And despite the inconvenient lumpiness, the same applies to restructuring, compensation payments and fines, which, after all, are cash outflows. There is a more principled basis for excluding impairments of asset values. These are balance sheet adjustments that typically catch up with historic over-payment or a long-term deterioration in market position. Many companies extend the argument about changes in paper values to the regular amortisation of intangibles. But, like property that is depreciated, this indicates the wearing out of an asset over a finite life. So an accrualsbased proxy for its replacement looks like a regular business cost. The proliferation of profit definitions, often for dubious reasons, needs to be tackled. 2

4 Principles Not Rules A Question of Judgment Need to clarify Main business and profit from Main business from other profit Profit from main business includes businesses that same sustainable growth rate should be expected. Investment in associates and other investments are treated differently when calculating corporate value. Investors would think, when classified as investment in associates, it tend to be included in corporate value. On preparers side, there used to be a trend to pretend having better EBITDA ratio by acquiring additional shares to change investment in associates to subsidiary. When evaluating by DCF, such change makes no difference, but if certain item in PL is emphasized, it could lead to the intention to control that item. Buy-side former asset manager, US investment company, Active fund We need to first think of what does principles-based standard mean. Shared the following using the past publishment (by the author) for getting to stand on the first place. Exercise of judgement is needed in principles-based standard Judgement needs to come with plenty explanation Principles-based standard shows direction instead of giving detailed rules Better outcome may be lead by not having detailed rules and leaving some space for judgement. Trust among the four is essential for principle-based standard. 3

5 Current disclosure situation in Japan no consistency in operating meaning Table: Current Values of "Share of profit(loss) of associates" by entity rank EntityName PL CF values displayed in PL (million yen) relative ratio to operating profit/loss 1 SoftBank Group Corp. N O* 375, ITOCHU Corporation - O 147, HONDA MOTOR CO.,LTD. N O 126, Marubeni Corporation - O 31, Sojitz Corporation N O 23, FUJITSU LIMITED N O 18, DENSO CORPORATION N O 5, DENTSU INC. N O 3, Hitachi Chemical Company,Ltd. N O* 3, DeNA Co.,Ltd. N O 1, Hitachi Capital Corporation - - 1, SBI Holdings, Inc. - O* 1, Yahoo Japan Corporation N - 1, KYB Corporation P O 1, Astellas Pharma Inc. P I 1, Asahi Glass Company,Limited P O* -2, Nippon Sheet Glass Company,Limited N I -3, NSK Ltd. P O* -4, KDDI CORPORATION P O* -5, JAPAN TOBACCO INC. P O* -6, SUMITOMO CORPORATION N O -53, MITSUI & CO.,LTD. - O -132, Mitsubishi Corporation - O -175, Judgement to include share of profit of associates in operating income seems not to relate to how large the value is. Judgement to include in operating income seems not surely relate to relevance to business. However, dividends received from these associates are classified as Operating activities in most cases. No consistency on the word "Operating" between PL and CF N P - defined as non-operating item defined as operating item no operating profit subtotal O "dividends received" classified in Operating activities O* "interest and dividends received" classified in Operating activities I "dividends received" classified in Investing activities Source: TRENDEPOT, TOYOKEIZAI Inc., Each company's latest FSA Filing Annual Reports 4

6 How investors are looking at companies business from PL (Business or not) Company F includes share of profit of associates in operating income, but I am convinced as it is clearly stated to have closely related business. Their disclosure is clear in other ways such as finance income/costs are separated as operating and non-operating; operating being foreign exchange gain/loss from goods, and nonoperating being foreign exchange gain/loss resulting from forwards contracts. Company N adopting IFRS from this FY, used to disclose each subsidiary as a segment, but they changed disclosure policy to sum up some subsidiaries on materiality-basis. A subsidiary NC had the highest profit rate up to 18 %, while others had rate below 10 %, but this subsidiary was summed up with others due to lack of materiality in sales. I am concerned about such change, because it would make company with highest profit rate out of view. In an Ad agency, they used to disclose revenue as gross profit under J-GAAP, but was changed to net profit under IFRS. Since business of ad agency is to earn commission, it is right to book commission on net-basis under IFRS, but gross data was extremely important to see how much commission is earned for media they cover, or to see if their product development is successful to produce additional value, and how these change over time compared with competitors. PL is a fundamental tool to monitor business model and competitiveness of a company. 5

7 Should equity in earnings of associates be included in operating income for Kameda Seika? Kameda Seika is making rice crackers, a traditional snack in Japan made from the prime ingredient in Japanese cuisine. Large funds, responsible governance (experience Retail sector) It is OK to be included Active fund targeting medsmall companies It should be included Long-term concentrated investment Instinctively, I feel we should watch this figure to look at company s future. We could look for equity in earnings of associates, but since it is close to main business I feel like operating 6

8 Adjusted operating income provided by information provider An Information provider said, Normally, we exclude extraordinary income/loss (one time income/expense). Share of profit/loss of associates is excluded as well. Reason for such treatment We are not trying to define alternative operating income. Users need benchmark that are consistent for many years. We need to answer the needs of various clients. These items depend on treatments in the past or the fact that some items are not disclosed in every quarterly report. Acquired In-Process R&D Merger Expense Disposal of Assets Asset Write-Down Impairment of Goodwill Impairment of Intangible Assets Sale of Business Legal Expense Restructuring Expense Insurance Settlements Other One Time Items It is not that we want IASB to define operating income as information providers do, but we want clear and precise disclosure so that we can recognize the substance. Before defining operating activity, we want IASB to require disclosing same item consistently in the face and notes of financial statements so we could adjust certain items for analysis. 7

9 What does investment in associates mean? Case of Trading company M Trading companies have many associated companies traditionally, and they include share of profit/loss of associates in EBITDA as important performance measure. On the other hand, classification between investments in associates and other investment is done based on IAS 28. There is a gap in accounting treatment when the voting rights is over or below 20%, which makes us feel awkward (that profit or loss arises when voting rights go past 20% in case our influence has slightly changed). Investors opinion -Trading companies usually have business related to resource overseas, generating profit sometimes larger than operating profit. -We might be able to say, "investment" is one of main business in trading companies. On the other hands share price of a company having large share of profit/loss of associates tends to be low against the profit level. (low PER) IAS28.5 If an entity holds, directly or indirectly (eg through subsidiaries), 20 per cent or more of the voting power of the investee, it is presumed that the entity has significant influence, unless it can be clearly demonstrated that this is not the case. IAS28.6 The existence of significant influence by an entity is usually evidenced in one or more of the following ways; (a) representation on the board of directors or equivalent governing body of the investee; (b) participation in policy-making processes, including participation in decisions about dividends or other distributions; (c) material transactions between the entity and its investee; (d) interchange of managerial personnel; or (e) provision of essential technical information. 8

10 Making clear profit from operating activities possible under Principle based accounting standard? From the discussion.. Making clear profit from operating activities - Why this is important for investors? -Analysts look at investment in associates from standpoint of predictability. If investment is related to main business and future profit can be expected, they evaluate in such way. If investment is not related to main business, we may discount such profit in evaluation. - What should be compared over years, even though company's structure changes? When analysts make estimation, some business from affiliates could be estimated together. In such case, they should be reported as operating. 9

11 Possible approaches Opinion of an accountant (previously standard-setter) There are three discussion points. First point suggested by today's discussion is that consecutiveness is important. This means whether or not to disclose sustainable profit rather than disclosing operating profit or what to include in operating profit. Therefore, this point is different from operating profit, but to consider disclosing sustainable profit in IFRS. Second point is about definition of investment in associates. Currently, under IFRS, if entity has significant influence on policy-making process; whether operating policy or financing policy, investment is classified as investment in associates. However, investors consider to be extension of business when having significant influence on operating policy, and that is why investment should be treated as operating. In such case, it is point of discussion whether or not including significant influence on financing policy should be reflected in the definition of investment in associates. Last point suggested is that share of profit of associates is profit that does not necessarily have corresponding cash-in, which is about Earnings Quality. We accept it to be included in operating profit, but since it does not have corresponding cash-in, additional disclosure may be required, and we need to discuss what kind of disclosure is needed in such case. One way would be to disclose dividends received, or fixed assets that associates hold, or if their impairment risk needs to be disclosed. Disclosure relating to Earnings Quality as such is a matter of discussion for the future. 10

12 Message to IASB To define operating activity in a principle-based way does not harm comparability. What harms comparability is the fact that definition of operating activity is not clear, that said, principle-based approach does not lead to lack of comparability. Significant influence in the standard does not include perspective of business. Investors put emphasis on influence to business. It is recommended to fill the gap between such recognition. Objectives of users vary and information providers provide multiple data to answer their needs. Operating income does not have to be the only one. It is required of IASB to have clear definition of line items to be commonly shared, taking into consideration how users utilize the data. If each line item becomes clear, quality of Taxonomy will be also improved. 11