One of the challenges faced by the International Accounting Standards Board (IASB) when developing IFRS 18 Presentation and Disclosure in Financial Statements was creating presentation requirements that improve comparability without producing results that make little or no sense for certain industries. The solution was a set of special requirements for entities whose main business activities involve investing in assets or providing finance to customers. This instalment of our AASB 18 series examines those requirements and the practical implications for affected entities.
In Part 2 of our AASB 18 series, we explored the three new profit or loss categories introduced by AASB 18 and how income and expenses are allocated between them.
Before an entity classifies income and expenses into the operating, investing and financing categories, it must first determine whether it has a specified main business activity. This assessment is a critical first step that sets the foundation for the classification exercise that follows and can have a significant impact on how operating profit is reported.
Why the need for specified main business activities?
For many entities, the classification rules in AASB 18 are reasonably straightforward. Interest income is generally investing, interest expense is generally financing, and operating profit more clearly represents the activities that generate revenue from the entity’s core operations.
However, AASB 18 recognises that these rules do not work equally well for every type of business.
Consider a bank. If interest income was classified in the investing category and interest expense in the financing category, the bank’s operating profit would bear little resemblance to its actual operating performance.
Similarly, for an investment property entity, rental income and fair value gains may represent the primary source of earnings. Classifying these items outside of operating profit would arguably obscure rather than enhance performance reporting.
To address this issue, AASB 18 provides modified classification requirements for entities that have specified main business activities.
What is a specified main business activity?
AASB 18 recognises two specified main business activities:
- Investing in particular types of assets; and
- Providing financing to customers.
It is important to note that entities do not need to identify all their main business activities. The focus is simply on determining whether investing in particular types of assets and/or providing finance to customers forms part of the entity’s main business activities as these are the only activities that trigger special classification requirements under AASB 18.
Where either or both activities represent a main business activity for an entity, special requirements apply when categorising and presenting items in the income statement. In certain cases, entities may also have accounting policy choices relating to the classification of certain income and expenses.
How is the assessment made?
Whether an entity has a specified main business activity is not a matter of choice. The assessment is based on the entity’s actual circumstances and requires judgement.
The standard is explicit in its requirement that the assessment should be supported by observable evidence rather than management preference. In other words, an entity cannot determine that investing in assets or providing finance to customers is a main business activity simply because doing so would result in a preferred income statement outcome.
In assessing whether a specified main business activity exists, AASB 18 places particular emphasis on two possible sources of evidence:
- The use of particular subtotals; and
- Segment information.
One indicator that investing in assets or providing finance to customers is a specified main business activity is the use of subtotals similar to gross profit that incorporate related income and expenses as a key measure of operating performance. Evidence may be found in how management monitors performance internally or how those measures are communicated externally to investors and other stakeholders.
Segment information may also provide evidence that investing in assets or providing financing to customers is a specified main business activity. In particular, where a reportable segment comprises a single investing or financing activity, this may indicate that the activity is an important contributor to the entity’s overall performance and therefore represents a main business activity. Although operating segments may also be relevant, AASB 18 places greater weight on reportable segments because they reflect activities that management considers significant enough to separately communicate to users of the financial statements.
Management should document the basis for its conclusion, including the evidence considered and how that evidence supports the assessment. This may include management reporting packs, budgets, strategic plans, annual reports, investor presentations or other public communications.
For some entities, such as banks and finance companies, the conclusion may be obvious. For more diversified groups, however, the assessment may require more analysis. A documented position will be particularly important for entities where the conclusion is not clear cut.
Whether an entity has a specified main business activity is not a ‘set and forget’ conclusion. The assessment is based on the facts and circumstances that exist at the time. If those facts and circumstances change, so too may the conclusion. Any such change is applied prospectively, meaning there is no need to revisit comparative amounts. Instead, AASB 18 requires disclosures that help users understand the effect of the change, including how relevant income and expense items were classified before and after the reassessment.
At what level is the assessment done?
Assessing whether an entity has a specified main business activity is done at the reporting entity level. Therefore, each reporting entity that prepares financial statements must perform its own assessment.
This means that in a group consisting of a parent and one or more subsidiaries, the assessment is undertaken separately for the consolidated group, the parent in its separate financial statements and each subsidiary in its own financial statements. As a result, different reporting entities within the same corporate group may reach different conclusions regarding their specified main business activities.
For example, a subsidiary may conclude that investing in assets is a specified main business activity in its own financial statements, while the consolidated group concludes that investing activities are not sufficiently significant to constitute a main business activity in the consolidated financial statements. Similarly, a consolidated group and a subsidiary may both conclude that providing finance to customers is a specified main business activity, whereas the parent that is a holding company might reach a different conclusion in its separate financial statements.
The practical consequence is that income and expenses may be classified differently in the financial statements of the group, the parent and individual subsidiaries. Additional consolidation adjustments may therefore be required when preparing the consolidated statement of profit or loss.
What changes when an entity has a specified main business activity?
The identification of specified main business activities is important because income and expenses that would ordinarily be classified as investing or financing may instead be classified as operating. The objective is to ensure that operating profit remains a meaningful measure of performance for entities whose business models revolve around investing activities or providing finance to customers.
The additional classification requirements do not apply to all income and expenses. Instead, they are limited to:
- Income generated by the asset;
- Income and expenses arising from the initial and subsequent measurement of the asset, including on derecognition; and
- Incremental expenses directly attributable to the acquisition or disposal of the asset.
Importantly, having a specified main business activity does not automatically result in all related income and expenses being classified in the operating category. The classification outcome depends on the nature of the underlying asset or liability and the specific requirements in AASB 18.
Examples of the types of income and expenses captured by these requirements include rental income, interest, dividends, depreciation, impairment losses and reversals, fair value gains and losses and income and expenses from the derecognition of the asset or from its classification and remeasurement as held for sale.
Below we explore the additional requirements that apply when an entity determines it has a specified main business activity.
Investing in assets as a main business activity
Entities that invest in assets as a main business activity have additional classification requirements to consider in applying AASB 18.
Importantly, these requirements do not apply to all investments, only the following:
- Investments in associates, joint ventures and unconsolidated subsidiaries accounted for at fair value through profit or loss or cost (that is, investments that are not equity accounted); and
- Other assets that generate a return individually and largely independently of other resources (excluding cash and cash equivalents which are discussed separately below).
Investments in associates, joint ventures or unconsolidated subsidiaries
Not all investment entities will be affected by the specified main business activity requirements.
AASB 18 does not permit income and expenses arising from investments in associates, joint ventures and unconsolidated subsidiaries that are accounted for using the equity method to be classified in the operating category. This applies even where investing in those investments forms part of the entity’s main business activities.
As a result, the specified main business activity assessment does not affect the classification outcome for equity-accounted investments. Income and expenses arising from these investments will always be classified within the investing category.
The position is different where investments in associates, joint ventures and unconsolidated subsidiaries are measured at fair value through profit or loss or at cost. In these circumstances, where investing in these investments is assessed as being a specified main business activity, related specified income and expenses are classified as operating rather than investing.
Recognising the significance of this distinction, AASB 18 includes transitional provisions for eligible entities such as venture capital organisations, mutual funds and some insurers. These entities may change their election for measuring an investment in an or associate or joint venture from the equity method to fair value through profit or loss when they first adopt AASB 18.
Other assets
If an entity invests in assets (other than cash and cash equivalents, associates, joint ventures and unconsolidated subsidiaries) that generate a return individually and largely independently of other resources, any specified income and expenses are classified in the operating category rather than the investing category. Examples of these types of assets include debt instruments, equity instruments, investment properties and rent receivables generated by such properties.
By contrast, where assets do not generate a return individually and largely independently of other resources, related income and expenses are classified in the operating category.
Cash and cash equivalents
Entities are not required to assess whether they have a specified main business activity of investing in cash and cash equivalents. However, where an entity has a specified main business activity of investing in financial assets (other than cash and cash equivalents, associates, joint ventures and unconsolidated subsidiaries) that generate a return individually and largely independently of the entity’s other resources, it is required to classify the income and expenses from cash and cash equivalents in the operating category.
If the entity provides financing to customers as a main business activity, then the classification requirements relating to cash and cash equivalents are more complex (see below).
Providing finance to customers as a main business activity
Entities that provide finance to customers as a main business activity also have additional classification requirements to consider when applying AASB 18.
These requirements recognise that, for lenders and similar entities, both the income earned from providing finance and the costs incurred in obtaining funding are often integral to the entity’s operating activities. Without special classification rules, operating profit may not provide a meaningful representation of performance.
The standard draws a distinction between funding that relates to providing finance to customers and funding that does not. In some circumstances, entities also have accounting policy choices regarding the classification of income and expenses arising from these funding arrangements.
The additional requirements apply to:
- Liabilities that arise solely from transactions involving the raising of finance;
- Other liabilities; and
- Cash and cash equivalents.
Liabilities arising solely from raising of finance
A liability arises solely from a transaction involving the raising of finance when the entity’s primary purpose for entering into the transaction is to obtain funds.
Examples include borrowings, bonds, debentures, and other funding arrangements entered into to obtain capital.
For most entities, income and expenses arising from these liabilities, such as interest expense, are classified in the financing category. However, where providing finance to customers is a specified main business activity, it must be assessed whether the liability relates to providing finance to customers.
Where it does, the related income and expenses are classified in the operating category. This reflects the fact that obtaining funding is a critical part of the entity’s business model. In much the same way that a retailer purchases inventory to generate sales revenue, a lender obtains funding to generate interest income from customers.
For liabilities that arise solely from the raising of finance but do not relate to providing finance to customers, AASB 18 permits an accounting policy choice. Entities may elect to classify the related income and expenses in either the operating or financing category.
The standard also recognises that some entities may be unable to distinguish between liabilities that relate to providing finance to customers and those that do not. In these cases, income and expenses from all such liabilities are classified in the operating category.
Other liabilities
The position differs for liabilities that do not arise solely from transactions involving the raising of finance.
Examples include lease liabilities, employee benefit obligations, trade payables and provisions that arise as part of the entity’s broader operating activities.
For these liabilities, the existence of a specified main business activity does not change the classification requirements. Instead, entities continue to apply the general requirements of AASB 18.
As a result, interest expense on lease liabilities, contract liabilities and defined benefit obligations remains classified in the financing category, while other income and expenses associated with these other liabilities are generally classified in the operating category.
Cash and cash equivalents
Cash and cash equivalents are subject to separate classification requirements.
Where income and expense from cash and cash equivalents relate to providing finance to customers, they are classified in the operating category.
Where they do not relate to providing finance to customers, entities that do not invest in financial assets as a specified main business activity may elect to classify the related income and expenses in either the operating or investing category. However, this election must be applied consistently with the classification adopted for funding arrangements that arise solely from transactions involving the raising of finance but do not relate to providing finance to customers.
As a result, entities cannot classify income and expenses from these funding arrangements in one category and income and expenses from cash and cash equivalents in another. The classifications must therefore be aligned.
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This article is part of our series exploring the key changes introduced by AASB 18 and what they mean for entities.
Click the links below to explore the rest of the series:
Part 1: An overview of the new disclosure standard
Part 2: Categorising income and expenses
Part 3: New subtotals and operating expense analysis requirements
Part 4: Management-defined performance measures
Part 5: Aggregation, disaggregation and labelling