Presentation of financial statements

There are a few differences between Ind AS-1, Presentation of Financial Statements, and IAS-1, which is the corresponding IFRS issued by the IASB. We shall discuss some of those differences.

Ind AS -1 mandates that an entity must provide analysis of expenses in the profit and loss account based on the nature of expenses. IAS 1 requires an entity to present an analysis of expenses recognised in profit or loss using a classification based on either their nature or their function within the equity. IAS-1 requires that if an entity decides to classify expenses by function, it shall disclose additional information on the nature of expenses.

I believe that carving out the option will better serve interest of investors and potential investors, and creditors, including lenders, who are the primary users of financial statements. Investors and potential investors are interested in the valuation of the company. They use information in ‘financial statements’ for forecasting cash flows that the entity will generate from year to year over a long period of time. Creditors use the information to evaluate credit risks.
Users of financial statements forecast cash flows based on the net profit, revenue and analysis of operating expenses based on their nature presented in the profit and loss account. They do not use gross profit or other profitability measures to forecast cash flows. This is the reason why IAS-1 requires all entities, which choose to analyse expenses based on functional classification, to provide analysis of expenses based on natural classification.

Finance literature has identified three value drivers, which determine the value of an entity. They are return on invested capital (ROIC), growth of ROIC and consequently growth of cash flows available for distribution to investors (free cash flow) and the cost of capital. ROIC is calculated using operating profit after tax in the numerator. Therefore, functional classification of expenses is redundant in the context of valuation of companies.

Presentation of an analysis of expenses based on functional classification could be misleading because allocation of expenses to different functions might be arbitrary and judgemental. IAS-1 observes “classification by function can provide more relevant information to users than the classification of expenses by nature, but allocating costs to functions may require arbitrary allocations and involve judgement”. Moreover, it involves cost, how so ever small it might be. Therefore, this “carve out” would benefit investors.

IAS-1 recognises the concept of comprehensive income and other comprehensive income. Other comprehensive income comprises of items of income or expenses, which accounting standards do not permit to recognise in profit or loss for the current period. For example, revaluation gain arising from the revaluation of property, plant and equipment is not recognised in profit or loss for the current period. Therefore, revaluation reserve is a component of other comprehensive income. Comprehensive income is the total of the profit (or loss) for the period and other comprehensive income. IAS-1 provides an option either to follow the single statement approach or to follow the two-statement approach. While in the single statement approach, all items of income and expense are recognised in the profit and loss account, in the two statements approach, two statements are prepared, one displaying components of profit or loss (separate profit and loss account) and the other beginning with profit or loss and displaying components of other comprehensive income. Ind AS-1 allows only the single statement approach. Carving out the option to adopt the two statement approach does not reduce the informative value of the profit and loss account.

There are some differences, which are trivial in nature, but avoid a change from the present practice for the sake of change only.

Ind AS-1 (and IAS-1) requires companies to disclose, among other things, sources of estimation uncertainty and information on the capital structure that enables users of its financial statements to evaluate the entity’s objectives, policies and processes for managing capital. Both the information will be very useful to both investors and creditors. Information on estimation uncertainty will help analysts to formulate their judgement on how to build those uncertainties in the valuation model. Information on capital will help analysts to estimate the target capital structure, which is used to estimate the discount rate. Discount rate is an important variable in DCF valuation models.

Ind-AS -1 will definitely improve the informative value of financial statements without creating undue hardship to entities.

Source: Economic Times

Thanks and Regards,
Sanchari Sinha,
Intern at DENIP Consultants Pvt. Ltd.