The accounting standards need to draw a clear and consistent distinction regarding the use of the two main measurement bases: fair value and depreciated cost. Depreciated cost should be the measurement basis for the non‑passive operating assets and liabilities, while, on the other hand, subject to applicability and cost/benefit considerations, there should be a preference for use of fair value for investment assets and financial liabilities. At the same time, it would be wise to isolate the impacts that are unrelated to the measurement of the current period’s performance – this being through use of other comprehensive income for operating activities (including subsequent recycling), along with separate presentation of the “revaluation line item” that relates to investing and financing activities.
The relatively quick development of fair‑value accounting along with the sporadic and non‑uniform use of other comprehensive income is presently creating a lack of uniformity in the accounting standards that has no clear or coherent basis. It is noted that the new conceptual framework, despite its attempt to address the matter, did not provide significant order for cases where an item of income or expense is recognised in other comprehensive income, including with respect to the question whether a subsequent recycling is to be executed, and left the resolution thereof to the International Accounting Standards Board.
The problem is both an absence of uniformity in the use of the different measurement bases and the use of other comprehensive income in different ways – which is completely incoherent. Presently, the most pronounced example of the problem with the use of other comprehensive income is an investment in shares that is accounted for in accordance with IFRS 9. Pursuant to the Standard, an investment in shares that is measured at fair value may be recorded using two alternative tracks – through profit or loss or through other comprehensive income, where the track is elected on a share-by-share basis with no requirement for consistency. Moreover, when the other comprehensive income track is chosen, subsequent recycling to profit or loss is not made even at the time of realisation, whereas when an investment in debentures is measured at fair value through other comprehensive income, a subsequent recycling is made.
The situation described above is extremely problematic in the eyes of investors, who are usually not well versed in all the accounting nuances, and quite naturally it causes them to retreat and distance themselves from financial statements. It is important to bear in mind that the strength of the business language cannot lie in an entry into the full range of its details but, rather, in providing a general understanding of its rationale, particularly where accounting experts are not involved. In the present situation, investors become confused and seek out alternative (and many times presentable) non‑GAAP measures, which essentially circumvent the accounting principles and are open to manipulations. This is well illustrated by the use of EBITDA, which was conceived as a tool for measuring multiples in technology companies and in recent years has become a legitimate performance measure, despite the fact that it always eliminates depreciation expenses.
The two main problems with financial statements at the present time
The presently existing incoherence in financial statements can be broken down into two main items: one relates to the absence of a clear, coherent principle regarding the use of the measurement bases and the other involves the inconsistent use of other comprehensive income. In order to improve the relevance of financial statements, the solution to the two above‑mentioned fundamental questions is embedded in a view of the accepted valuation model – DCF. As is known, the first and central stage of the model is calculation of the enterprise value (EV) by discounting the free cash flows at a discount rate that reflects a suitable risk premium. For this purpose, the forecast period must be sufficiently long in order to reflect the elements that distinguish the enterprise and give it surplus value. Added to this is the present value of the cash flows in the period beyond the forecast period wherein the enterprise operates “normally”. The assumption is that beyond the forecast period all of the enterprise’s unique advantages are exhausted and as a result of competitive pressures it will provide its owners a normal return. The second stage is addition of the economic value of surplus assets that are not part of the core activities, while the third stage is subtraction of the economic value of financial liabilities (interest‑bearing debt). From the standpoint of investors, this economic view could greatly assist in solving the two fundamental questions noted above. For this purpose, the assets and liabilities in the statement of financial position must be divided into three different categories: operating, investing and financing – similar to the manner in which this is done in the new proposal for change of the structure of the financial statements.
In regular companies, operating assets and liabilities include items such as inventory, trade receivables, property, plant and equipment, prepaid expenses, trade payables and accrued expenses. The classification of assets and liabilities to each of these categories is derived from the nature of the activities. Thus, for example, investment property and investments in securities in a regular company belong to investing activities, whereas investment property for a rental property company or investments in securities for financial institutions, are part of operating activities.
The proposed model: Principle No. 1 – Measurement of Assets and Liabilities
The measurement aspect will be addressed first. Assets and liabilities classified as operating that are not passive in nature (such as inventory, trade receivables, prepaid expenses, property, plant and equipment and trade payables) are to be measured based on their depreciated cost. The rationale for this is to express the results of the activities as they are incurred, pursuant to the concept of recognition of revenue.
Principle No. 1: Measurement matrix – nature of the asset vs. its functionality
In contrast, assets relating to investing activities, such as investments in securities and investment property, which are considered to be surplus assets, are to be measured based on their fair values, as is presently done in many cases with respect to investment property. Where essentially passive assets are classified as operating, such as in the case of investment property in a rental property company or investments in securities in financial institutions (for example banks), it would be appropriate that their measurement in the statement of financial position be made based on fair value. However, as explained below, use is made of other comprehensive income in order to defer the impact of the revaluations on measurement of profit or loss. A question that must be dealt with is how to view the main financial assets of commercial banks, which constitute the credit granted to businesses and households, namely unlisted loans, and it would be logical to deem them to be active assets owing to the business nature of the above‑mentioned activities.
In this context, the existing vacuum regarding measurement of intangible assets may not be ignored – mainly where R&D projects are involved, regarding which the usual practice in most cases is to recognise most of the project’s costs as expenses in the statement of profit or loss. The solution must lie in viewing the costs incurred as their economic value, such that subject to periodic impairment testing these amounts will be recognised as assets. As things presently stand, the financial statements of many companies, particularly in the technology industry, are distorted – both from the standpoint of measurement of the expenses as well as regarding measurement of the equity. For purposes of illustration, the financial statements of start‑up companies, which are almost entirely made up of R&D expenses and, as a result, minimal equity, lose a large degree of their relevance. In the future as well, in a case where a company is successful, the relevance of its statement of financial position and statement of profit or loss suffers as a result of not recognising the said assets and, in turn, also not recognising the amortisation component as cost of sales.
Similar to assets relating to investing activities, measurement of liabilities – primarily financial debt (bank loans and debentures issued) must also veer in the direction of fair value, obviously subject to applicability and cost/benefit considerations. As an interim solution, measurement at fair value could be permitted (but not required). It is noted that already for more than a decade the option exists under U.S. GAAP to measure every financial asset or liability at fair value as part of the FVO (Fair Value Option) and at the present time IFRS includes a requirement to provide disclosure of their fair value in the notes to the annual financial statements.
The proposed model: Principle No. 2 – Separation of the “revaluation line item” and use of other comprehensive income as a “buffer” for operating activities
The second principle of the proposed model is isolation of the impacts that are unrelated to the measurement of the current period’s performance. For this purpose, it is important to distinguish between, on the one hand, items that belong to the “operating activities” category – since for these items use will be made of the other comprehensive income tool and thereafter a recycling and, on the other hand, items that belong to the “investing activities” and “financing activities” categories, since for these items separate recording will be made of the “revaluation line item” in the relevant category of profit or loss. The difference between the categories relates solely to the use or non‑use of the other comprehensive income tool rather than to the manner of calculating the revaluations. The proposed concept for the manner of calculating the revaluations is based on the article “Returning the Relevancy of the P&L”, which was authored together with Mr. Ehud Lurie, CPA, and published in “The CPA Journal”.
The proposed concept of separating the revaluations can be illustrated by means of investment property, which is an investment item that already at the present time is measured in many cases at fair value and pursuant to the proposed model it will be measured only at fair value. Under the proposed model, investment property in a regular company will be classified as “investing activities” and in a rental property company as “operating activities”.
As a simple illustration, it is assumed that the fair value of the real estate at the beginning of the period is $100 million and at the end of the period is $110 million. The revenue from rents during the period amounts to $5 million, the depreciation expenses based on the depreciated cost method are $2 million and the maintenance expenses are $0.4 million. In such a case, the revaluation during the period will be $12 million, because even though the depreciation expenses reduced the carrying amount of the asset by $2 million, its fair value increased by $10 million ($110 million – $100 million), and therefore the excess “revaluation” is $12 million ($10 million + $2 million). The net movement in the statement of financial position during the period is an increase in the carrying amount of the investment property of $10 million and an increase in cash of $4.6 million ($5 million – $0.4 million).
Therefore, for a regular company wherein investment property is classified as “investing activities”, the results of the investing activities will include the following line items:
On the other hand, where a rental property company is involved, the operating profit in the amount of $2.6 million will be recognised in profit or loss, while the revaluation will be recognised in other comprehensive income, in the amount of $12 million, up to the time the building is sold (at which time the revaluation will be recycled to profit or loss as a separate line item within operating activities).
It is noted that this accounting treatment is essentially the same as the accounting treatment presently applied in accordance with IFRS 9 with respect to an investment in debentures measured at fair value through other comprehensive income, since the revaluation recognised in other comprehensive income represents the difference between the fair value and the amortised cost. In this case, the measurement based on amortised cost impacts profit or loss, and at the time of realisation the other comprehensive income is recycled to profit or loss.
The focus now turns to the manner of using other comprehensive income which, pursuant to the proposed model, is used only for operating activities. This separation within operating activities is important in two main cases. The first case is for certain investment assets and financial liabilities that are measured at fair value pursuant to Principle No. 1 above, yet belong to the operating category – such as investment property in rental property companies or investments in securities in financial institutions. The second case relates to certain operating assets and liabilities not measured at fair value, such as in the case of exchange differences of foreign operations that are unrelated to the measurement of the profit in the eyes of investors, or in the case of measurement of actuarial liabilities that includes a “remeasurement” component that stems from changes in demographic and financial assumptions (actuarial gains and losses) but does not relate to the current period’s performance.
Principle No. 2: Presentation of profit or loss items which are unrelated to performance measurement
(*) For this purpose, a notional operating result will be recorded based on depreciated cost (see the illustration regarding investment property above).
It is important to note that in the new international conceptual framework (after its revision in the last decade) – one of the two main objectives of financial statements, in addition to provision of useful information to the users thereof in order to make investment decisions, is giving shareholders the capability of evaluating management’s performance – and therefore such an isolation of the impacts on measurement of management’s performance is very important for meeting this significant goal.
Nonetheless, as opposed to the presently existing requirements, it is important to create a situation wherein measurement of performance as part of profit or loss stands independently.
Before signing off, set forth below are a number of points of emphasis and clarification (including some conceptual points) with respect to application of the proposed model in several particular cases:
- Actuarial liabilities – the presently existing situation in accordance with IAS 19, wherein the actuarial gains and losses are permanently “removed” from measurement of profit or loss, is unhealthy and a reasonable solution needs to be found that will include them in profit or loss. In this regard, it pays to note the U.S. GAAP solution that makes a recycling on a straight‑line basis over the period up to the expected retirement date.
- Derivatives – where speculative activities are involved, measurement at fair value through profit or loss within investing activities is appropriate. The same is also true regarding derivatives used for hedging purposes that meet the criteria for hedge accounting – the present accounting treatment that creates a P&L match to the hedged item is appropriate – whether it is included in the operating part of profit or loss or in the investing/financing part. However, it is clearly advisable to examine whether it is appropriate to recognise in other comprehensive income the revaluation to fair value component of derivatives used for economic hedging purposes that do not meet the criteria for hedge accounting.
- Loans received and debentures issued – where financial liabilities are involved, such as loans received and debentures issued, which pursuant to the proposed model will be measured at fair value, the current interest expenses (based on the depreciated cost model) will continue to be included in profit or loss, whereas the revaluations to fair value in each period will be reported as an item of other comprehensive income.
- Investments in associates – it appears that the time is ripe to discontinue measuring investments in associates based on the outdated equity method of accounting and move to measuring them at fair value. The proposed accounting treatment for investment property is also relevant to equity‑accounted associates – such that measurement based on the equity method of accounting will be included in profit or loss, whereas the revaluations to fair value will be included in other comprehensive income up to the time the investment is realised.
The bottom line
To sum up, it can be demonstrated that in a relatively simple manner, based on the accepted concept in valuations, the manner of measuring assets and liabilities can be properly addressed in accordance with their functionality, while at the same time also properly attending to the matter of use of other comprehensive income. The other comprehensive income shall constitute a kind of “buffer” that assists in measuring the operating performance – by means of separating out non‑indicative components with respect to operating assets and liabilities. This “buffer” is a tool that bridges the gap between the wish for statement of financial position measurement that is relevant and an accurate measurement of performance results. Concurrently, there will be an improvement in the manner of presentation of the investing and financing results in such a way that will provide a separate presentation of the “revaluation line item”.
Regarding other comprehensive income, it is important to note that a clear resolution is needed – similar to the situation presently existing under U.S. GAAP, where other comprehensive income must be recycled sooner or later to profit or loss. Currently, where there are certain items that will never be included in profit or loss, a “bypass route” exists with respect to measurement of performance. If this is, in fact, the resolution, it would be preferable to make use of the “other income and expenses” category in the statement of profit or loss, which would allow investors to eliminate this item when measuring the normalised earnings. This conclusion is further reinforced in light of the far‑reaching proposal to include disclosure in the financial statements of management performance measures – that is, how management believes its normalised earnings should be calculated.
These steps are coherent with the new proposal regarding the manner of presentation of the results and appropriately meet the needs of investors. Most importantly – a joint understanding will now exist between preparers of financial statements and users thereof, which is essential for increasing investor confidence and the extent of their reliance on the financial statements.