Speech: The Primary Financial Statements project—a game changer in financial reporting?

When: 6 March 2019

Where: Mexico City, Mexico

Chair of the International Accounting Standards Board (Board) Hans Hoogervorst delivered a speech at the Seminario international sobre NIIF y NIF, organised by the Consejo Mexicano de Normas de Información Financiera. Mr Hoogervorst described the global nature of IFRS Standards, the recently issued major Standards and the Board's work on improving the formatting and structure in IFRS financial statements through its Primary Financial Statements project.

It is a pleasure to be here in Mexico City once again.

Let me begin by thanking the Consejo Mexicano de Normas de Información Financiera (CINIF) for hosting this important conference. In particular, I would like to thank my good friend Felipe Perez Cervantes, who serves as Chairman of CINIF and is the former President of the Grupo Latinoamericano de Emisores de Normas de Información Financiera, or GLENIF. GLENIF does an excellent job representing the diverse views across Latin America.

I also note the immense contribution of my fellow Board member Amaro Gomes. Amaro steps down from the IASB in a few months’ time. He has worked tirelessly to make sure the views of Latin America are heard loud and clear, and he will be sorely missed by us all. A new Board member from this region will be announced shortly, and I look forward to their help continuing the good work of Amaro.

Finally, let me also acknowledge the contribution of Guillermo Babatz, our Trustee from Mexico, and Laura Ramirez, Deputy General Director for Accounting Regulation at the CNBV and a member of our Advisory Council.

It is some time since I last gave a speech in this city. Five years ago, to be precise. Back then, we had had just issued IFRS 9 Financial Instruments, and had yet to finish the other big standards—IFRS 15 Revenue from Contracts with Customers, IFRS 16 Leases and IFRS 17 Insurance Contracts. All those standards are now issued, and with the exception of IFRS 17, fully in effect.

These were big projects for us, and also for you when it came to implementing them. Has the ‘gain’ of better financial information been worth the ‘pain’ of implementation? That’s something I’ll touch on in a minute.

But first, let’s briefly recap on where we are with IFRS Standards around the world.

IFRS as global standards

Most of you will be familiar with the IFRS story. Since 2001, an ever-increasing number of jurisdictions have adopted our Standards. In 2005, the European Union led a first wave of jurisdictions adopting IFRS Standards. That was closely followed by a second wave of adopters, including the large Latin American jurisdictions such as Mexico and Brazil. Today, of 166 jurisdictions researched by the IFRS Foundation, 144—roughly nine out of ten jurisdictions—have adopted IFRS Standards. That includes fifteen of the G20 major economies. That’s a remarkable achievement in such a short period of time. Here in Latin America, jurisdictions representing more than 99% of regional GDP have now adopted IFRS Standards.

Moreover, we continue to see continued progress in other parts of the world. Jurisdictions such as China, India and Indonesia have achieved substantial convergence between their national accounting requirements and IFRS Standards, although some differences remain. China especially is now very close. Many of its big companies show identical results under IFRS and Chinese GAAP.

In Japan, companies have had the option to adopt IFRS since 2012. After a relatively slow start, we’re now seeing many of the major Japanese companies adopting or planning to adopt IFRS. To date, almost 200 companies representing more than 30% of the total market capitalisation are using IFRS Standards. Only last month, the CFO of Toyota—Japan’s largest company—stated his intention to adopt IFRS Standards in the near future.

That leaves the US as the only large jurisdiction where adoption has stalled. But even there, IFRS plays an important role. More than 500 foreign companies listed in the US report using IFRS Standards, with a total market capitalisation of more than seven trillion dollarsⁱ. while US investors have more than four trillion dollars of mutual fundsⁱⁱ invested outside of the US, much of that in IFRS jurisdictions.

In summary, although the map of the world is not yet complete, IFRS has now become the de-facto global language of financial reporting.

Major standards

Let me now turn to the substance of our Standards.

As I mentioned earlier, the big four standards—IFRS 9, 15, 16 and 17—are all issued. With the exception of IFRS 17, they are now being used in the market.

It’s too early to say with any certainty how the new standards are performing, while our due process includes formal ‘post-implementation reviews’ of these standards to come. In the meantime, I thought it would be useful to share with you some early feedback.

IFRS 9 is the first of these Standards. The global financial crisis added urgency to our plans of modernising our financial instruments standard IAS 39. During the downturn it became clear that there was too much latitude for discretion in loan loss provisioning. That meant much of it was too little, and too late.

We set out to fix these problems by introducing a forward-looking, expected credit loss model. The new Standard was issued in 2014 and came into effect last year—so we’re now starting to see the impact it is having.

The transition for banks has been challenging but seems to have gone OK. Overall, provisions have increased, but not unduly so—perhaps due to the benign economic conditions in much of the world. We’re also starting to see the benefits of a forward-looking loan loss provisioning model that requires banks to consider future events. A good example of this is Brexit in the UK, where many banks are now disclosing loan loss provisions against the risk of a disorderly Brexitⁱⁱⁱ. Thanks to IFRS 9, we can also see which banks are choosing not to provision against Brexit, which is itself an interesting piece of information. I doubt this information would have been disclosed under the old standard.

Mexico has adopted IFRS 9, but it is not yet mandatory for use by Mexican banks. Mexican banks are strongly capitalised, adhering to the Basel requirements, and it would be great if they could also comply with international accounting standards.

Next on the roster is IFRS 15 Revenue from Contracts with Customers. Most people felt the old IFRS requirements on revenue recognition lacked sufficient detail, while revenue recognition under various US GAAP standards was too detailed and conflicting in certain areas. That’s why we worked with the FASB to develop an entirely new, converged standard. Our version of that is IFRS 15, and the new standard also came into effect last year.

The good news is that IFRS 15 seems to be working well. According to a recent EY survey of US CFOs and CIOs^iv, 94% felt that, over the long term, revenue recognition changes will deliver a value return that will exceed the investment they will make, up from 62% last year. Reported benefits include improving data quality and data-driven insights into business performance, enhancing risk awareness and identifying strategic cost reduction opportunities.

I should note that this is a US survey of attitudes towards the US revenue standard, but that is virtually identical to IFRS 15 and is consistent with feedback we hear elsewhere in the world.

Next is IFRS 16. The old leases standard had a somewhat arbitrary distinction between finance leases recorded on the balance sheet, and operating leases that were not. At the time we issued IFRS 16, listed companies around the world were estimated to have around 3.3 trillion US dollars of lease liabilities, with around 85% of those being operating leases and therefore not recorded on the balance sheet.

To illustrate the problem, when US retailer Circuit City went bust in 2009, its balance sheet recorded debt of $50 million, but off-balance sheet leasing liabilities of $3.3 billion —65 times more liabilities than reported. Savvy investors would use various techniques to add back in the missing information, but the old approach was clearly deficient.

IFRS 16 fixes these problems by bringing all leases onto the balance sheet, and by matching it with a corresponding ‘right to use’ asset. The new standard has only been in place for a matter of months, and we’re starting to see some striking outcomes. In the UK, for example, analysis published last month^v showed that the UK’s top 350 listed companies alone will disclose an additional £180 billion of leasing liabilities that will now be fully visible to investors.

Finally, we have IFRS 17—our new insurance contracts standard. It has been a long time coming, but it can’t come into effect soon enough. Pre-IFRS 17, the insurance sector was an outlier because there was no proper international standard for insurance contracts. Pretty much anything went, which meant the same transactions were being accounted for differently, by different companies in different jurisdictions. For example, our own analysis of discount rates used by life insurers showed that 43% used current rates, 35% used historic rates and 22% used a mix of the two.

IFRS 17 fixes this by requiring all insurance contracts to be accounted for in a consistent manner, benefiting both investors and insurance companies. Insurance obligations will be accounted for using current values—instead of historical cost. The information will be updated regularly, providing more useful information to users of financial statements.

Moreover, IFRS 17 will contribute towards long-term financial stability; for example, by requiring that losses embedded in onerous contracts are recognised immediately, instead of the current practice where contracts with losses can disappear by being bundled together with profitable contracts.

As we have done with other major standards, we are working closely with the insurance industry to help ease implementation, through our Transition Resource Group and other forms of outreach. Based on this feedback, we have proposed a one-year extension to 2022 for the effective date of IFRS 17, and we are also looking to make some targeted adjustments to the standard. I am convinced that IFRS 17 will be seen as the gold standard for insurance accounting internationally and I strongly hope that Mexico will also decide to reap the benefits of this standard.

Primary Financial Statements

That brings you up to date on the big standards. So, the question is then ‘what next’?

Pretty much everything I’ve spoken about thus far relates to the substance of our standards—recognition and measurement. Currently, the Board is focusing more on how financial information is presented. We call this our ‘Better Communication’ initiative. One of the most important parts of Better Communication is the Primary Financial Statements project.

The objective of the Primary Financial Statements project is to provide better formatting and structure in IFRS financial statements, especially in the income statement. Currently the IFRS income statement is relatively form-free. We define Revenue and Profit or Loss but not all that much in between.

In practice, both preparers and investors like to use subtotals to better explain and understand performance. Our lack of guidance in this respect has had the unintended consequence of stimulating the use of self-defined subtotals, also known as non-GAAP measures. Non-GAAP measures can be useful to explain different aspects of the performance of a company and we do not intend to root them out.

However, non-GAAP measures are often non-comparable. Subtotals like Operating Profit and EBITDA are very commonly used, but in practice companies define these subtotals in very different ways. Moreover, many non-GAAP measures tend to paint a very rosy picture of a company’s performance, almost always showing a result that is better than the official IFRS numbers. This is the second reason why we decided it was important the IFRS Standards themselves provide more detail and structure.

Providing more structure to the financial statements is also important as more financial information is produced and consumed digitally. There is more and more automated investing going on and increasingly artificial intelligence is used to help investors digest information from vast numbers of financial statements. The greater the amount of data consumed by investors and the greater the reliance on technology, the more important it is that data is properly structured, consistently defined and tagged.

The first subtotal we have looked at is operating profit. This is the most commonly used subtotal around the world and it currently lacks an IFRS definition. We have decided to define operating profit as profit excluding financing, tax and income/expenses from investments. We are convinced that our definition of operating profit shows what most would view as the results of a company’s main business activities.

The IASB understands that the definition of operating profit as profit excluding financing, tax and income/expenses from investments does not work for financial entities, such as banks. For a bank, clearly providing loans to customers is a main business activity, so excluding all financing expenses from operating profit makes no sense. For this reason, the IASB has decided to require financial entities to include expenses from financing activities relating to the provision of financing to customers in operating profit. We have found similar solutions for insurers and investment companies.

In practice, many companies may have a slightly different view on what they consider their operating profit and they may be tempted to present an adjusted non-GAAP measure of operating profit. However, the advantage of having an IFRS-defined subtotal of operating profit is twofold. First, investors will have at least a common denominator of operating profit that is comparable across companies and industries. Secondly, if companies want to present an adjusted measure of operating profit, the official IFRS definition will serve as an additional anchor in the income statement to which the adjusted number can be reconciled. This way, adjustments to operating profit will become much more transparent, leading to better comparability.

Below Operating Profit, we have created what can loosely be called an Investment Category. This category includes income and expenses from investments, from financial investments to associates and joint ventures. Investors tend to look at such investments separately from operating profit.

A second important subtotal that the IASB has decided to define is what we call Profit before Financing and Tax. As the name indicates, this subtotal excludes expenses from financing activities (such as interest expense on loans or bonds) and tax. Users often want to compare companies’ performance before the effects of financing and this subtotal enables that comparison. In other words, the profit before financing and tax subtotal enables comparison of companies with different capital structures. It creates better comparability of the performance of companies independent of their degree of leverage.

The Board has looked seriously at the possibility of us trying to define and own the very commonly used non-GAAP measures of EBIT and EBITDA. The problem with the terms EBIT and EBITDA is that they have evolved gradually over time, without clear underlying concepts. The acronyms are used very loosely and their components often differ significantly from their literal meaning. The lack of conceptual clarity and precision makes the use of these subtotals very problematical. Apart from that, there are many people who have serious qualms about the information value of a subtotal like EBITDA.

Moreover, over time preparers and users might start using the subtotals that we have defined—Operating Income and Profit before Finance and Tax—as building blocks for their own analyses. They might find our definitions workable for their own subtotals, whether EBIT or EBITDA or others, and they might wish to reduce the need for reconciliation. Over time, some spontaneous convergence between non-GAAP and GAAP might take place.

In addition to improving the structure of the income statement, we have developed guidance that will improve disaggregation. Currently, all too often, many components of the income statement are lumped together in ‘other income or expenses’. For many investors this is a big source of frustration and our guidance will make excessive aggregation much more difficult.

Finally, we will require companies to disclose in the notes which components of income or expense they judge to be ‘unusual’, either in size or in frequency. Adjustments for unusual items are now very commonly done in the realm of non-GAAP. Clearly, this is important information for investors in their efforts to predict future cash flows. Yet, it is also one of the areas of non-GAAP where a lot of cherry picking is going on. Unsurprisingly, companies tend to focus on what they see as unusual expenditures rather than on identifying windfall profits. While it will never be perfectly possible to identify unusual items, we aim to develop principles that will strengthen discipline in this area.

Overall, our decisions thus far will create much more structure in the income statement and will definitely enhance comparability. The improved structure will make it much easier for users to find the components for the analysis that they prefer. The increased transparency around the adjustments that companies make in their non-GAAP measures will provide the investor with a lot of information about the underlying strategy of management. Do these adjustments reflect a credible strategy for long-term value creation, or do they seem inspired by a wish to embellish results? Our work is not done yet, and we still have some tough nuts to crack. I am optimistic, though, that our work on the primary financial statements can become a real game changer in reporting.

Close

This brings me to the end of my speech.

I was asked to provide an update on IFRS Standards around the world, and to talk about the impact of the big four standards. Hopefully I have done that. I’ve also used this opportunity to update you on the primary financial statements project—a game changer for us, and a real opportunity to improve the communications effectiveness of financial statements.

Mexico is an important member of the IFRS family. We are receptive to your feedback, and greatly appreciate your ongoing support for our work.

Thank you

ⁱ SEC (2018), “Statement in Connection with the 2018 AICPA Conference on Current SEC and PCAOB Developments”

ⁱⁱ SEC (2017), “A U.S. Imperative: High-Quality, Globally Accepted Accounting Standards”

ⁱⁱⁱ Financial Times (2019), “Big banks divided on provisions for Brexit defaults” (subscription required)

^iv EY (2019), “Survey finds public companies making changes to their disclosures; many companies expect significant post-implementation work”

^v AccountancyDaily (2019), “IFRS 16 set to pull £180bn onto FTSE 350 balance sheets”