Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
CA Prajwal Jha Assistant Manager Research and Advisory, Taxmann
Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
CA Prajwal Jha Assistant Manager Research and Advisory, Taxmann
Contents 1.
Introduction
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2. Operating profit or loss represents the result of the operating category
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3. Profit or loss before financing and income taxes includes the investing category
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4. The classification of assets and liabilities determines what is included in operating profit
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5. Main business activities can affect the classification
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6. A specific exception applies to certain entities
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7. Impact on analysis of financial performance
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8. Conclusion
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1. Introduction The proposed Ind AS 118, Presentation and Disclosure in Financial Statements, introduces significant changes to the presentation of financial performance in the statement of profit and loss. One of the key changes is the introduction of two defined subtotals, “Operating Profit or Loss” and “Profit or Loss before Financing and Income Taxes”. These subtotals are intended to provide a more consistent structure for the statement of profit and loss and improve comparability between entities. Importantly, the proposed requirements do not change how income and expenses are measured; rather, they determine how such amounts are classified and presented. This article explains the composition of these two subtotals, the categories of income and expenses that determine their calculation, and the special requirements applicable to entities having specified main business activities.
2. Operating profit or loss represents the result of the operating category Ind AS 118 provides that operating profit or loss comprises all income and expenses classified in the operating category. Therefore, operating profit or loss is not determined by simply taking revenue and deducting a predefined list of operating expenses. Instead, it is the result of applying the classification requirements of Ind AS 118. Further, it explains the operating category as the category comprising all income and expenses included in profit or loss that are not classified in another category. Consequently, items that do not meet the requirements for classification as investing, financing, income taxes or discontinued operations generally form part of operating profit or loss. The significance of this approach is that operating profit or loss is intended to capture the income and expenses arising from the entity’s operations after applying the classification requirements of Ind AS 118. Illustration Consider the following information for Alpha Ltd.: Particulars
₹ lakh
Category
Revenue from operations
1,000
Operating
Employee benefits
(200)
Operating
Raw material consumed
(400)
Operating
Other operating expenses
(150)
Operating
Gain on disposal of operating PPE
20
Operating
Dividend income from investment
15
Investing
Interest income on bank deposits
10
Investing
Interest expense on bank borrowing
(50)
Financing
Income tax expense
(70)
Income Tax
Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
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The operating profit or loss would be: ₹1,000 − ₹200 − ₹400 − ₹150 + ₹20 = ₹270 lakh The ₹25 lakh of investing income is not included in operating profit because it belongs to the investing category. Similarly, financing costs and income tax are excluded.
3. Profit or loss before financing and income taxes includes the investing category Ind AS 118 also establishes the second important subtotal. It provides that profit or loss before financing and income taxes comprises operating profit or loss together with all income and expenses classified in the investing category. Thus, the subtotal can be understood through the following relationship: Operating profit or loss + Income and expenses classified in the investing category = Profit or loss before financing and income taxes This means that the subtotal is broader than operating profit or loss. While operating profit or loss captures only the operating category, profit or loss before financing and income taxes also incorporates the results of the investing category. For example, assume that an entity has operating profit of ₹100 crore and earns ₹15 crore of income from an investment that is classified in the investing category. If there are no other investing-category expenses, the entity’s profit or loss before financing and income taxes would be ₹115 crore. The distinction is important because an entity may earn significant returns from assets or investments that are classified in the investing category. Such returns do not form part of operating profit or loss, but they are included in the subtotal representing profit or loss before financing and income taxes. Continuing the above Illustration Operating profit = ₹270 lakh Investing income: Dividend income = ₹15 lakh Interest income = ₹10 lakh Therefore, Profit or loss before financing and income taxes = ₹270 lakh + ₹25 lakh = ₹295 lakh. The ₹50 lakh financing expense and ₹70 lakh income tax expense are excluded from this subtotal.
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Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
4. The classification of assets and liabilities determines what is included in operating profit The composition of operating profit is closely connected with the classification of income and expenses arising from assets and liabilities. For assets that generate returns individually and largely independently of an entity’s other resources, the related income and expenses will generally be considered for classification in the investing category. Examples include certain debt or equity investments and investment properties. The related items may include interest income, dividend income, rental income, depreciation, impairment and fair value gains or losses. However, assets that are used in combination with other resources to produce or supply goods or services generally do not generate returns independently. Income and expenses arising from such assets are therefore generally classified in the operating category. For instance, the depreciation of machinery used in a manufacturing process is associated with the entity’s operating activities and would generally form part of operating profit or loss. In contrast, income from an investment that generates returns independently of the entity’s other resources may be classified in the investing category and would therefore be excluded from operating profit. The same principle applies to liabilities. Ind AS 118 distinguishes between liabilities arising from transactions involving only the raising of finance and liabilities arising from other transactions. Interest expense on a borrowing that represents financing would generally fall within the financing category. On the other hand, expenses associated with trade payables or other operating liabilities may remain within the operating category. Therefore, the line between operating profit and amounts presented below operating profit is determined by the nature of the underlying transaction and the classification requirements of Ind AS 118.
5. Main business activities can affect the classification The classification principles also recognise that the nature of an entity’s main business activities can affect how certain income and expenses are classified. Ind AS 118 also requires an entity to assess whether investing in assets or providing financing to customers is a main business activity. An entity may have more than one main business activity. The Exposure Draft provides examples such as investment entities, investment property companies and insurers for entities that may invest in assets as a main business activity. Banks and other lending institutions are examples of entities that may provide financing to customers as a main business activity.
Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
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This requirement is important because an activity that may be investing or financing in nature for one entity may form part of the entity’s operating activities when that activity represents its main business activity. For example, interest income earned by a manufacturing entity from investments may generally be associated with its investing activities. However, for a bank whose principal business is providing financing to customers, income from loans to customers is closely connected with its main business activity. The classification requirements therefore recognise this difference in the nature of the two entities’ activities. The assessment is based on evidence and management judgement. Furthermore, paragraph B33 of Ind AS 118 indicates that one factor that may provide evidence is whether the entity uses a subtotal similar to gross profit as an important indicator of operating performance, whether that subtotal is used internally or externally.
6. A specific exception applies to certain entities Ind AS 118 also contains a specific exception to the requirement to present profit or loss before financing and income taxes. The exception applies where an entity applies the accounting policy permitted by paragraph 65(a)(ii) of Ind AS 118 to classify certain income and expenses arising from liabilities that do not relate to providing financing to customers in the operating category. In such circumstances, the entity is not required to present profit or loss before financing and income taxes. Instead, the entity considers the requirements relating to useful structured summaries and determines whether an additional subtotal after operating profit or loss and before the financing category would provide useful information. For example, the Exposure Draft notes that in such cases, an entity could present a subtotal comprising operating profit or loss together with income and expenses from investments accounted for using the equity method, where that subtotal provides a useful structured summary of the entity’s financial performance. Further, it clarifies that where an entity presents such an additional subtotal, it cannot give the subtotal a label that would incorrectly suggest that it excludes financing amounts. The label must faithfully describe the amounts included in the subtotal.
7. Impact on analysis of financial performance The proposed subtotals can change the way analysts and investors evaluate an entity’s financial performance.
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Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
Operating profit or loss provides an indication of the net income and expenses classified in the operating category. It therefore focuses attention on the entity’s operating activities after applying the classification requirements of Ind AS 118. Profit or loss before financing and income taxes goes one step further by incorporating the investing category. It allows users to assess performance before the effects of financing and income taxes while also considering investment-related returns. The distinction becomes particularly useful when comparing entities with different capital structures or investment portfolios. It can help users separately assess operating performance, investment returns and the effect of financing decision.
8. Conclusion The proposed Ind AS 118 introduces a structured approach to the presentation of financial performance by requiring income and expenses to be classified into five categories and by introducing defined subtotals in the statement of profit and loss. Operating profit or loss comprises all income and expenses classified in the operating category, whereas profit or loss before financing and income taxes combines operating profit or loss with the income and expenses classified in the investing category. However, the classification is not purely mechanical. The assessment of whether investing in assets or providing financing to customers constitutes a specified main business activity can shift certain amounts from the investing or financing categories into the operating category. Consequently, understanding these subtotals requires consideration of both the nature of the income or expense and the entity’s business activities. This framework is intended to provide users with a more consistent and comparable view of financial performance without changing the underlying measurement of income, expenses or profit.
Insights on Ind AS 118 Understanding the Operating Profit and Profit or Loss before Financing and Income Taxes
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