19 July 2013

IASB/Coopen: Framework rethink will shape the landscape for investors

Coopen highlights two key issues covered in the Discussion Paper that are likely to be of particular interest to investors and that could also result in changes to Standards sooner rather than later. These are:

1. the reporting of performance, including what should be reported in profit or loss and what should be reported outside profit or loss in other comprehensive income; and
2. the accounting for items classified as equity and the dilutive effects of some financing instruments on common shareholders.

Performance reporting and other comprehensive income (OCI)

Issue

Most investors will be aware that not all items of income and expense are included in profit or loss. Some items of income and expense (mainly unrealised remeasurements) are reported as other comprehensive income (OCI). This is in effect a secondary category of income which is not included in earnings per share (EPS) and which, as a result, generally gets less attention from investors.

There are some who regard the distinction between profit or loss and OCI to be artificial in that both include items of income and expense (eg gains and losses). They believe that gains and losses can have a variety of characteristics and that it would be better to fully describe these characteristics within a single statement of comprehensive income, which might well include one or more subtotals, but where there is no special status given to profit or loss.

Decisions about the use of OCI and whether to require reclassification of items reported in OCI have been made in individual Standards over many years. While these decisions were not made at random, most would agree that the conceptual basis for each decision is not necessarily consistent with other decisions and that this is an area that would benefit from a better framework.

Potential solutions

To address this issue, the Discussion Paper identifies three broad categories of income and expense that might qualify for recognition in OCI: bridging items; mismatched remeasurements; transitory remeasurements.

In the Discussion Paper, the IASB reviews two possible approaches to using OCI which would comprise some or all of the above categories. The first is referred to as a ‘narrow’ approach where OCI would include only bridging items and mismatched remeasurements. The second is referred to as a ‘broad’ approach. This approach would include not only bridging items and mismatched remeasurements, but also some transitory remeasurements. The narrow approach would define what is in OCI quite tightly, and would restrict the use of OCI considerably. The broad approach would permit wider use of OCI, but rely on a rather less precise definition of what it includes. Both approaches have pros and cons, and the IASB has not yet developed a preference for one over the other. Input from investors will be one important factor for the IASB to consider when it decides where its preference lies.

The use of OCI and the issue of reclassification to profit or loss create much debate. Some feel that OCI should not exist at all. Some accept that OCI is a useful way of disaggregating gains and losses but believe that reclassification makes no sense because, in effect, it results in the same item being recognised twice. The Discussion Paper does not provide definitive answers to these issues but rather different ways one might consider using OCI. A decision will only come with finalisation of the framework and, indeed, in subsequent Standards or revisions to Standards. However, it does provide a sound basis for starting an informed debate that the IASB hopes will include investors’ views. Clearly changes in how income and expenses are presented will have a significant impact on investors.

Equity and dilutive effects on common shareholders

Issue

The current IFRS framework defines a liability as an obligation for the company to deliver cash; equity is then a residual representing other claims on the business cash flows. However, the measurement of items classified as equity may not always provide the information that investors need to make capital allocation decisions.

Potential solution

In this Discussion Paper, the IASB has put forward proposals which may provide investors with more relevant information about the impact of other equity claims. The main change the IASB proposes is to expand the role of the existing statement of changes in equity to include updated information about the measurement of equity claims other than those of common shareholders (the Discussion Paper calls them ‘secondary equity claims’).

The idea in the Discussion Paper is to require the remeasurement of such ‘secondary’ equity claims through the statement of changes in equity. This is not as radical as it might seem, because in effect entities already do this for non-controlling interests. Equity claims of minority shareholders in a partially-owned subsidiary are also classified as equity in the consolidated accounts. Their measurement is updated each period to reflect changes in the underlying net assets attributable to these minority shareholders. Such amounts are not reported as deductions in arriving at comprehensive income but as part of the statement of changes in equity. In effect, the minority’s share of group profit shows how the wealth created in the period is allocated between the different equity claims.

The Discussion Paper goes into some detail about the possible use of the statement of changes in equity to give more information about the effects of equity claims. However, the actual framework, when finalised, would merely outline the underlying concepts, including the definitions of the various elements and the objective regarding remeasurement. The detail of how secondary equity claims would be remeasured is something that would be addressed in an actual revision to a Standard, which would, of course, go through our usual deliberations and exposure for public comment.

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