PFRS 18: Confidently navigating changes in financial reporting

(First of two parts)

IN BRIEF:

• The new IFRS 18 standard, effective Jan. 1,  2027, will transform financial statement presentations by mandating a structured approach to income and expenses, enhancing clarity and comparability for users.

• Key changes include defined categories for income and expenses, the introduction of new subtotals like operating profit or loss, and stricter presentation and disclosure requirements to improve transparency in financial reporting.

• Companies will need to adapt their reporting systems and engage with stakeholders to ensure compliance and effectively communicate their financial performance under the new standard.

In 2027, users of financial statements will encounter a transformative shift in how companies present their financial performance. The new standard, IFRS 18 Presentation and Disclosure in Financial Statements, issued by the International Accounting Standards Board (IASB) in April 2024, is set to replace the existing IAS 1 Presentation of Financial Statements.

In the Philippines, this standard was adopted as PFRS 18, which will be effective for periods beginning on or after Jan. 1, 2027. This change is not merely a compliance exercise; it represents a fundamental rethinking of how financial performance is communicated to stakeholders.

Financial reporting standards provide a framework that helps organizations present their financial performance in a manner that is understandable to users, including investors, regulators, and analysts. The introduction of PFRS 18 aims to enhance these qualities, addressing existing challenges and improving the overall quality of financial reporting.

PFRS 18 introduces several significant changes that will reshape the structure of the statement of profit or loss. These changes are designed to enhance clarity and comparability across entities, making it easier for users to assess financial performance.

New structure for statement of profit or loss and defined categories: At its core, the statement of profit or loss provides a window into how an entity has translated its strategy into financial results. However, the existing practice for preparing the statement of profit or loss allows for significant variability in how amounts are reported. To improve the structure of the statement of profit or loss, PFRS 18 requires companies to classify income and expenses into one of five distinct categories: operating, investing, financing, income taxes, and discontinued operations. This classification aims to provide users with a clearer understanding of the sources of income and expenses.

Introduction of new subtotals: The standard introduces two new subtotals — operating profit or loss and profit or loss before financing and income taxes — which means that certain subtotals will soon become more visible and comparable across companies. Together with the new categories, these new subtotals will create a more structured narrative, allowing users to better understand operating results, evaluate investment impacts and see the cost of financing.

Management-defined performance measures (MPMs): PFRS 18 requires entities to disclose MPMs within their financial statements, providing insight into how management views the financial performance of the entity.

Enhanced disclosure requirements: The standard imposes stricter disclosure requirements, ensuring that descriptions and labels used in financial statements faithfully represent the characteristics of items presented and disclosed. This ensures that users have access to relevant information about the measures used to assess performance.

ADDRESSING CURRENT GAPS IN FINANCIAL REPORTING
The existing standard, PAS 1, requires the presentation of profit or loss but does not require any specific subtotals, leading to inconsistencies and a lack of comparability. For instance, the commonly used term operating profit lacks a standardized definition across different entities. This results in varying interpretations and calculations, making it challenging for users to compare financial information between companies, even those operating within the same industry.

To address these issues, PFRS 18 requires companies to classify income and expenses into one of five categories:

Operating: Includes income and expenses arising from the entity’s main business activities, such as the revenue from the sale of products and services, and all items not required to be classified in any of the other categories.

Investing: Typically includes income and expenses from cash and cash equivalents and income from rental properties and dividends from financial instrument investments that are not part of the entity’s main business activities. It also includes the share of earnings and losses from equity-accounted investments.

Financing: Covers income and expenses related to liabilities arising from transactions involving only the raising of finance, such as bank loans, and interest expenses like interest expense on lease liabilities.

Income Taxes: Includes all income tax-related expenses and income recognized in profit or loss.

Discontinued Operations: Includes income and expenses from operations that have been discontinued.

Together, these five defined categories do not just reorganize line items on the statement of profit or loss. Instead, they also introduce greater discipline into how financial performance is framed and presented by sharpening the distinction between the main business activities of the entity and its ancillary activities.

CLARIFYING SPECIFIED MAIN BUSINESS ACTIVITIES
There have been concerns that when applying the general requirements for classifying income and expenses, certain entities need to classify the income and expenses from their main business activities in categories other than the operating category. In response, PFRS 18 introduces the concept of specified main business activities. Under PFRS 18, entities need to assess if they have a specified main business activity of investing in assets (e.g., investment property companies) and/or providing financing to customers (e.g., banks).

Consider a bank, XYZ Bank, which invests in financial assets like bonds and shares. Under PFRS 18, if XYZ Bank determines that investing in such financial assets is a main business activity, it can classify the interest and dividend income that they generate in the operating category, providing a clearer picture of its financial performance.

Similarly, consider a real estate entity, ABC Company, which invests in non-financial assets like land and buildings that are classified as investment properties. Under the new standard, ABC Company can classify rental income from those properties and certain expenses like depreciation expense in the operating category if it assesses that investing in such assets is a specified main business activity. This classification helps users easily identify the core business activities of the entity.

With PFRS 18 now anchoring the classification requirements to an entity’s specified main business activities, what will qualify as “operating” will no longer simply be a matter of preference, but of whether an item of income or expense arises from what an entity is really doing at its core.

IMPROVING COMPARABILITY THROUGH DEFINED SUBTOTALS
In order to improve comparability across financial statements, PFRS 18 introduces two new defined subtotals:

Operating Profit or Loss: This comprises all income and expenses classified in the operating category, providing a clear view of the profitability of the core business operations.

Profit or Loss Before Financing and Income Taxes: This includes operating profit or loss along with all income and expenses classified in the investing category. It offers insight into the overall profitability, allowing users to analyze and compare performance before considering financing costs and tax implications. It will also provide an opportunity for analysts and investors to compare the results of operations of entities independent of how they finance their operations.

The introduction of these defined subtotals enhances the ability of users to compare financial performance across different entities. For instance, investors can more easily assess the operating performance of companies within the same industry, leading to more informed investment decisions.

Given the potential changes to how subtotals are calculated under PFRS 18 compared to their legacy definitions, entities also need to consider the impact on how key performance indicators are currently measured and evaluated. There may also be potential impact on the terms and provisions of contracts, management incentive structures and covenants that are currently tied to those subtotals.

COMPLIANCE BEYOND NUMBERS
While the changes introduced by PFRS 18 focus on improving the presentation of financial statements, they also require companies to evaluate their reporting systems. This may involve redesigning charts of accounts, recategorizing certain items, and modifying existing controls.

The shake-up in financial reporting that PFRS 18 brings may also change the way entities currently tell their story. This means that companies should consider engaging early with analysts, investors, creditors, regulators and other stakeholders to discuss how the new standard will affect their financial reporting.

These changes mean companies must ensure that existing policies, processes and governance structures can accommodate the new requirements and deliver the enhanced transparency that the new standard requires.

In the second part of this article, we will discuss how, under PFRS 18, Management-Defined Performance Measures (MPMs) will soon move to the financial statements, along with the enhanced guidance on disclosures of financial information and the implications for companies as they prepare for its implementation.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinions expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Aris C. Malantic is the financial accounting advisory services (FAAS) leader of SGV & Co, and Dwayne G. Ignacio is a FAAS senior manager from SGV & Co.