Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss Editorial Team Research and Advisory, Taxmann
Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss Editorial Team Research and Advisory, Taxmann
CONTENTS 1.
Introduction
5
2.
Operating Profit or Loss – A Defined Subtotal
5
3.
Determination of Operating Profit or Loss under Ind AS 118
6
4.
Operating Profit or Loss does not represent Recurring or Core Business Profit
7
5.
Profit or Loss before Financing and Income Taxes
7
6.
Distinguishing Operating Profit or Loss from Profit or Loss b efore Financing and Income Taxes
7
Impact of an Entity’s Specified Main Business Activities on the Defined Subtotals
8
8.
Defined Subtotals and Other Subtotals
9
9.
Defined Subtotals and Management-Defined Performance Measures
9
7.
10. Defined Subtotals and Comparability of Financial Performance
10
11. Do the Defined Subtotals change the amount of Profit or Loss?
10
12. Practical Implications of the Defined Subtotals for Entities
11
13. Audit Considerations relating to the Defined Subtotals
11
14. Conclusion
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1. Introduction One of the significant presentation changes proposed by Ind AS 118, Presentation and Disclosure in Financial Statements (hereinafter referred to as the “Ind AS 118” or “the standard”), is the introduction of two defined subtotals in the statement of profit or loss, namely “operating profit or loss” and “profit or loss before financing and income taxes”. Under the existing presentation practices, entities may present measures such as operating profit, EBIT or profit before finance costs based on their own understanding and presentation practices. Consequently, similar measures may be calculated differently by different entities. Ind AS 118 seeks to bring greater consistency to the presentation of financial performance by prescribing defined subtotals within the statement of profit or loss. Importantly, these changes do not alter the measurement of profit or loss. Rather, they determine how income and expenses already recognised in accordance with applicable Ind AS are classified and presented to arrive at the prescribed subtotals. The proposed Standard requires entities to present operating profit or loss and profit or loss before financing and income taxes in the statement of profit or loss, unless presentation is prohibited in specified circumstances. The requirements therefore need to be considered together with the classification of income and expenses into the operating, investing, financing, income taxes and discontinued operations categories discussed earlier in this series. This article explains the meaning of these subtotals, how they are derived and how they differ from other commonly used performance measures.
2. Operating Profit or Loss – A Defined Subtotal Ind AS 118 introduces operating profit or loss as a defined subtotal to be presented in the statement of profit or loss. The subtotal is determined after including income and expenses classified in the operating category and before the income and expenses classified in the investing, financing, income taxes and discontinued operations categories. Accordingly, the operating profit or loss provides a structured measure of the financial performance arising from the entity’s operating category. The important point is that the term “operating” under Ind AS 118 does not simply mean the entity’s principal or core business activity. The operating category is the residual category after applying the requirements for classifying income and expenses into the investing, financing, income taxes and discontinued operations categories. Therefore, an item may form part of operating profit even though management may not regard it as arising from its principal business activity. For example, an unusual or volatile expense arising from an entity’s operations does
Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
5
not cease to be operating merely because it is non-recurring or unusual. Similarly, an income or expense item is not classified outside the operating category merely because management does not regard it as part of the entity’s core business; its classification is determined by applying the specific requirements of the Standard. Thus, operating profit under Ind AS 118 should not be understood as a measure limited only to recurring or core business activities.
3. Determination of Operating Profit or Loss under Ind AS 118 The determination of operating profit or loss can be understood through the following simplified structure: Particulars
Category
Revenue
Operating, subject to applicable requirements
Other income
Depending upon the nature of income
Operating expenses
Operating, subject to applicable requirements
Operating profit or loss
Defined subtotal
Income and expenses from specified invest- Investing ments Profit or loss before financing and income taxes
Defined subtotal
Income and expenses relating to financing
Financing
Income tax expense or income
Income taxes
Income and expenses from discontinued op- Discontinued operations erations Profit or loss
Total
The above structure is illustrative. The actual line items and their classification will depend on the nature of the entity and the specific requirements of Ind AS 118. The important feature is that the operating profit or loss subtotal is positioned before the investing and financing categories. This provides users with a consistent starting point for understanding the results of the operating category.
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Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
4. Operating Profit or Loss does not represent Recurring or Core Business Profit A common misunderstanding may be to equate operating profit with recurring or sustainable profit. Ind AS 118 does not make recurrence the basis for determining whether an item is operating. The classification depends on the requirements applicable to the five categories. For example, suppose an entity incurs a significant restructuring cost during the year. The expense may be unusual and may not be expected to recur. However, its unusual or non-recurring nature, by itself, does not result in the expense being removed from the operating category. Similarly, a gain or loss arising from a transaction that is unusual for the entity is not automatically excluded from operating profit. This distinction is particularly important because entities may currently use labels such as “adjusted operating profit” to exclude items considered unusual or exceptional. Such measures may potentially fall within the MPM requirements if they meet the conditions prescribed by Ind AS 118. However, the defined operating profit under Ind AS 118 is determined in accordance with the Standard and cannot be adjusted merely because management considers a particular operating item unusual.
5. Profit or Loss before Financing and Income Taxes The second defined subtotal introduced by Ind AS 118 is “profit or loss before financing and income taxes.” This subtotal is presented after the operating and investing categories but before the financing and income taxes categories. This subtotal is required unless its presentation is prohibited in specified circumstances under the Standard, including certain circumstances involving an entity whose specified main business activity is providing financing to customers. The subtotal therefore provides users with information about the entity’s financial performance before the effects of financing and income taxes. It comprises operating profit or loss together with income and expenses classified in the investing category.
6. Distinguishing Operating Profit or Loss from Profit or Loss b efore Financing and Income Taxes The two subtotals provide different information. Operating profit or loss reflects the income and expenses classified in the operating category, whereas profit or loss before
Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
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financing and income taxes goes one step further by incorporating the investing category while excluding the effects of financing and income taxes. The distinction can be understood with the help of a simple example of a manufacturing company. Assume that the company has revenue and other operating income of ₹1,000 crore and operating expenses of ₹800 crore, resulting in operating profit of ₹200 crore. This represents the net result of the income and expenses classified in the operating category. The company also earns ₹30 crore from investments and has a ₹20 crore share of profit from an associate. After considering the net ₹50 crore effect of these investing activities, the company reports profit before financing and income taxes of ₹250 crore. This measure therefore reflects the combined results of the operating and investing categories, while excluding the effects of financing and income taxes. The company thereafter incurs finance costs of ₹60 crore, which are classified in the financing category. This results in profit before income taxes of ₹190 crore. Finally, after recognising income tax expense of ₹50 crore, the company reports profit for the year of ₹140 crore. Thus, operating profit of ₹200 crore, profit before financing and income taxes of ₹250 crore and profit before income taxes of ₹190 crore provide different perspectives on the company’s financial performance. Each subtotal incorporates a different set of income and expenses and excludes the effects that are reflected in the subsequent categories.
7. Impact of an Entity’s Specified Main Business Activities on the Defined Subtotals The composition of the defined subtotals may vary depending on the nature of an entity’s main business activities. Ind AS 118 contains specific requirements for entities whose specified main business activities include investing in assets or providing financing to customers. This is relevant because where investing in assets or providing financing to customers is a specified main business activity, the Standard requires certain income and expenses that would otherwise be classified in the investing or financing category to be classified in the operating category. The assessment of whether an entity has such a specified main business activity is made at the reporting-entity level and should be supported by relevant evidence rather than being based solely on management’s assertion. For example, where providing financing to customers is a specified main business activity of an entity, certain income and expenses arising from such financing activities are classified in the operating category and, accordingly, are considered in determining operating profit or loss in accordance with the applicable requirements of Ind AS 118. Accordingly, the composition of operating profit or loss may differ between entities depending on the nature of their specified main business activities. The defined subtotal
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Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
therefore provides a consistent basis for classification and presentation, although the items included in that subtotal may differ between entities.
8. Defined Subtotals and Other Subtotals The defined subtotals prescribed by Ind AS 118 should be distinguished from other subtotals that an entity may present in the statement of profit or loss. Ind AS 118 permits an entity to present additional subtotals where such presentation provides a useful structured summary of the entity’s income and expenses. Such additional subtotals are determined based on the requirements of the Standard and the nature of the entity’s activities. For example, an entity may present a gross profit or loss subtotal in addition to operating profit or loss, where such presentation provides relevant information about its financial performance. The presence of an additional subtotal does not change the nature of the defined subtotals. Operating profit or loss and profit or loss before financing and income taxes remain the subtotals specifically defined by Ind AS 118. Therefore, an entity should clearly distinguish between a subtotal prescribed by Ind AS 118 and any additional subtotal presented to provide a useful structured summary of income and expenses.
9. Defined Subtotals and Management-Defined Performance Measures The defined subtotals should also be distinguished from management-defined performance measures (MPMs). An entity may communicate other measures of financial performance that reflect management’s view of a particular aspect of its financial performance. Where such a measure meets the definition of an MPM under Ind AS 118, the specific disclosure requirements relating to MPMs apply. For example, management may communicate an adjusted operating profit after excluding certain expenses that it considers unusual. Such an adjusted measure is different from the operating profit or loss defined under Ind AS 118. Operating profit or loss cannot be adjusted merely because management considers a particular income or expense to be unusual or non-recurring. The defined subtotal is determined by applying the classification and presentation requirements of Ind AS 118. This distinction is important because a defined subtotal and an MPM may appear similar but serve different purposes. The defined subtotal provides a prescribed point in the
Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
9
statement of profit or loss, whereas an MPM reflects management’s view of a particular aspect of financial performance and is subject to separate disclosure requirements.
10. Defined Subtotals and Comparability of Financial Performance One of the important consequences of introducing defined subtotals is greater consistency in the presentation of financial performance. Under existing practices, entities may use terms such as operating profit, EBIT or profit before finance costs and tax, while applying different approaches to determine those amounts. As a result, similar terminology may not always represent comparable measures. Ind AS 118 addresses this issue by prescribing defined subtotals that are determined in accordance with specified requirements. However, the introduction of defined subtotals does not mean that the composition of operating profit or loss will be identical across all entities. Differences in the nature of an entity’s main business activities may result in different income and expenses being classified in the operating category. Accordingly, the defined subtotals provide greater consistency in how financial performance is presented, while the nature of the entity’s activities remains relevant when analysing the underlying performance.
11. Do the Defined Subtotals change the amount of Profit or Loss? The introduction of the two defined subtotals does not, by itself, change the amount of profit or loss recognised by an entity. The requirements primarily affect the classification, presentation and disclosure of income and expenses and, consequently, the amounts reported as particular subtotals. They do not, by themselves, change the total profit or loss recognised by the entity. For example, where an income or expense is already recognised under the applicable Ind AS, its classification in the operating, investing or financing category may affect the amount reported as operating profit or loss or profit or loss before financing and income taxes. However, that classification does not, by itself, change the underlying amount of income or expense recognised. The principal effect is therefore on the presentation of financial performance and the information provided through the statement of profit or loss.
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Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
12. Practical Implications of the Defined Subtotals for Entities The introduction of the defined subtotals will require entities to review the existing presentation of their statement of profit or loss. The entity should assess whether the income and expenses currently included in measures such as operating profit or profit before finance costs and tax are classified in accordance with the requirements of Ind AS 118. The existing statement of profit or loss should also be reviewed to determine whether the defined subtotals are presented at the appropriate points and whether any additional subtotals currently presented continue to provide a useful structured summary. Further, entities should separately identify performance measures communicated by management outside the financial statements and assess whether any such measures meet the definition of an MPM under Ind AS 118. Accordingly, implementation of the defined subtotal requirements is not merely a matter of inserting two additional figures into the statement of profit or loss. It requires the underlying classification and presentation of income and expenses to be reviewed in the context of the requirements of Ind AS 118.
13. Audit Considerations relating to the Defined Subtotals The defined subtotals will also require consideration during the audit of financial statements prepared under Ind AS 118. The auditor would need to evaluate whether the underlying income and expenses have been appropriately classified and whether the resulting operating profit or loss and profit or loss before financing and income taxes have been correctly determined. The auditor should also consider the presentation of any additional subtotals and whether they are consistent with the requirements relating to a useful structured summary of income and expenses. Where management communicates other performance measures, the auditor would need to distinguish those measures from the defined subtotals and consider the applicable requirements relating to MPMs. Accordingly, the audit consideration of the defined subtotals would involve not only checking the arithmetic accuracy of the amounts presented, but also understanding the classification decisions underlying those amounts.
Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
11
14. Conclusion The proposed introduction of operating profit or loss and profit or loss before financing and income taxes represents an important change in the presentation of financial performance under the proposed Ind AS 118. Operating profit or loss reflects the income and expenses classified in the operating category, while profit or loss before financing and income taxes incorporates the investing category before the effects of financing and income taxes. The defined subtotals are intended to provide a consistent basis for presenting financial performance. At the same time, their underlying composition may differ depending on the nature of an entity’s main business activities and the classification requirements applicable to it. The significance of these subtotals therefore lies primarily in standardising their basis of presentation rather than changing the underlying measurement of profit or loss.
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Insights on proposed Ind AS 118 Understanding the Defined Subtotals in the Statement of Profit or Loss
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