Most investors make extensive use of operating profit to assess company performance and as a starting point for valuation. But operating profit, like many company-provided subtotals, is not defined by IFRS; it is largely up to companies to decide what subtotals to include and even what to call them. However, the IASB may soon bring an end to this operating profit ‘free for all’.
The proposal will lead to significant changes to the presentation of financial statements, notably the income statement, and end the current diversity in presentation of income from associates and joint ventures. We examine some of the changes and the impact on financial analysis and valuation methods.
It might come as a surprise that operating profit is not defined by IFRS, considering how important this metric is for investors. Subtotals in the income statement are encouraged, but there is limited guidance on individual metrics or overall required structure.
This variety in presentation makes it difficult to compare companies and has prompted the IASB to publish a consultation on new proposals1The Exposure Draft ‘General Presentation and Disclosures’ was published in December 2019 and is part of the IASB’s wider Better Communication project. The comment deadline is in September 2020. The exposure draft can be found here and the supporting ‘snapshot’ summary here. to improve presentation and disclosure in financial statements, particularly the income statement. We broadly support the proposals and think that they will be highly beneficial for investors. We will communicate our own views to the IASB and encourage all investors to do likewise; follow this link to find out how. The IASB would welcome your input.
A brief summary of the proposals is included in the table below.
|Profit and loss categories||The profit and loss statement additionally analysed into 3 broad categories – operating, investing and financing. |
Operating represents a company’s main business activities, although it is defined as a residual.
Investing is income and expenses related to investments that largely generate income independently of other resources.
Financing is interest expense on debt and other liabilities less interest income on cash and cash equivalents.
Separate guidance on how to deal with financial institutions and other companies for which investing and the provision of finance is their main business activity.
|Profit and loss subtotals||Three new subtotals: 1) Operating profit or loss, 2) Operating profit plus income and expenses from integral associates and joint ventures and 3) Profit before financing and income tax.|
|Classification and presentation of associates and joint ventures||Associates and joint ventures classified as either integral or non-integral. In profit and loss the income from integral associates and joint ventures to be included immediately below operating profit, income from non-integral associates and joint ventures is included as part of investment income.|
|Aggregation and disaggregation||Guidance on how items in the primary financial statements and notes should be disaggregated, with an emphasis on separately presenting items that have different characteristics.|
|Unusual items||A requirement to separately disclose unusual items – those that are not expected to recur in the foreseeable future.|
|Management performance measures||Guidance on how alternative performance or non-IFRS measures should be disclosed in financial statements, including when they are permitted to be presented in profit and loss as a separate line item and the explanations and disclosures that must be presented in the notes.|
|Cash flow statements||A requirement that the calculation of operating cash flow be based on (and the indirect derivation should start with) operating profit. Removal of certain existing options regarding how items are presented.|
Our focus for this article is the first three subjects in the table.
Operating profit … consistency and comparability at last
The Exposure Draft proposals, if enacted, means that companies would be required to present pre-tax income and expenses in three main categories: operating, investing and financing2There are further categories for income from integral associates, tax and discontinued operations.. The operating category is further split into operating profit and income from integral associates and joint ventures, which we discuss below. In addition, companies should present three subtotals: ‘Operating profit’, ‘Operating profit and income and expenses from integral associates and joint ventures’ and ‘Profit before financing and tax’.
Here is an illustration of what the statement of profit or loss would look like for a non-financial company applying the proposals.
Proposed new profit and loss format
We strongly support the introduction of a mandatory subtotal ‘operating profit’. This should improve comparability for investors and better facilitate equity valuation. Although operating profit is already commonly presented in financial statements, it can be defined (and labelled) more or less as companies wish. Sometimes it may include what we would regard as financing items, such as the interest expense accruing on pension liabilities, whereas other companies report these below operating profit. Sometimes operating profit excludes one-time or otherwise unusual items which may be reported as ‘other’ income and expense, but sometimes not. The variations are endless.
Operating profit is very important in equity analysis. It is used for analysing operating performance, including growth and margins. In DCF analysis operating profit less tax related to that profit (NOPAT) commonly forms the starting point for determining enterprise free cash flow. NOPAT is also often used in return calculations. Having to check and adjust the measures provided by companies is time consuming and likely to result in errors. Data providers may do this for you but, even then, one cannot be sure comparability is achieved. Separately presenting and improving the consistency of operating profit is good for investors and has been long overdue3The IASB started work on ‘Financial statement presentation in 2003 and even managed a draft of an ED in 2007. The financial crisis amongst other things, stopped that attempt. Let’s hope this time we will see some change..
You might think that defining operating profit is straightforward – pit could be income and expenses from the company’s trading activities or profit derived from revenue generated through the supply of goods and services to customers. However, in financial reporting the notion of operating has always been a challenge, particularly given the diversity of corporate activities. In the ED the IASB describes operating profit as ‘income and expenses from a company’s main business activities’ but actually defines it as a residual category. In other words, operating profit comprises all income and expenses that are not classified as integral associates and joint ventures, investing, financing, income taxes or discontinued operations. We support the approach and believe that it will lead to a definition of operating profit that is close to how you would wish to interpret it for equity analysis and valuation.
New investing and financing categories
The investing, category includes income and expenses from investments, such as interest income, impairment losses and their reversal, gains and losses on disposal, and fair value gains and losses for assets reported at fair value through profit and loss. Investments are defined as those assets that generate a return individually and largely independently, of other resources held by an entity. This might include a portfolio of financial assets, such as equity holdings in other companies, certain derivatives not applied in a hedging relationship, and investment properties.
We think separating income from investments is a significant step forward. Currently, companies make different choices regarding presentation, notably income from investments in associates and joint ventures.
The financing category includes income from cash and cash equivalents, income and expenses on both liabilities arising from financing activities, and on other liabilities where an interest accretion applies. We particularly welcome the proposed presentation of income and expense from other liabilities, including defined benefit pension schemes. As we have previously highlighted in our article ‘Enterprise value: calculation and miscalculation’, pensions, environmental and other debt-like non-financial obligations are best treated as part of financing for enterprise value based analysis and valuation.
In addition to giving more clarity regarding operating profit, the proposal also resolves the confusion about whether operating profit and EBIT (Earnings Before Interest and Taxes) are the same thing or not. Some regard them as the same whereas others regard EBIT as including more than just operating profit, such as investment income. In effect, EBIT now becomes ‘profit or loss before financing and income tax’, which equals operating profit plus associates and other investment income.
Overall, we believe the IASB proposal will significantly improve comparability of key performance metrics across companies. The split of items between operating, financing and investing also makes it easier to apply enterprise value based methods such as discounted cash flow, residual income and valuation multiples.
However, we believe that the IASB should have gone further. The clear classification in the income statement between operating, investing and financing should be extended to the balance sheet. In the cash flow statement a similar classification is already used but unfortunately it is not entirely consistant. A ‘cohesive’ approach to all of the primary financial statements, with similar categories, classifications and disaggregation, would be very beneficial to investors.
What about financial institutions?
At first sight, it looks like the IASB’s approach would create challenges for financial institutions because their operations involve activities that would be labelled as financing or investing in the new approach. However, if you are a bank or insurance analyst, then the new proposals will likely have little impact. The IASB proposes to require certain interest income and expense to be included in the operating result when a company’s main business activity involves the provision of financing to its customers or investing in financial assets. Of much more relevance for you is the widespread changes to insurance accounting coming in 2023, with the implementation of the new standard IFRS 17 Insurance Contracts.
Presentation of income from associates and joint ventures
One of the more significant changes proposed by the IASB is to the presentation of income from associates and joint ventures accounted for under the equity method. The objective is to improve information by mandating presentation below operating profit and by analysing this equity accounted income between two new categories.
Although IAS 1 requires presentation of the share of profit or loss of associates and joint ventures, accounted for using the equity method as a separate line item, it does not specify its location. As a result, there is significant variation in practice. A particular distinction is the presentation of income from associates above or below the operating profit line. Research by the IASB revealed that, of the companies they looked at, 30% presented this item above operating profit or EBIT and 70% below.
An interesting example is the two Nordic companies in the Telecom Equipment industry. Ericsson presents income from investments in associates above operating income, whereas Nokia presents it below. This variation makes it difficult to compare performance and financial ratios. A particular problem is the calculation of operating margin, which is a key metric to assess performance. As reported revenues do not include any revenues of associates or joint ventures, operating profit should not include any income from associates or joint ventures to produce a valid calculation of operating margin.
The IASB proposal is to require the presentation of income from associates and joint ventures below operating profit. This should end the current diversity in practice and makes the calculation and comparison of operating margins easier. In addition, the IASB also proposes to split income from associates and joint ventures into two categories – integral and non integral. This results in the following presentation.
Classification of associates and the effect on profit measures
The classification as integral or non-integral is based on whether there is a “significant interdependency between the entity and the associate”. This could be evidenced by having integrated lines of business, sharing a brand or through having a customer / supplier relationship. If such an interdependency exists then the associate or joint venture would be classified as integral. Non-integral investments would be those that generate returns “individually and largely independently of the other assets of the entity”.
Clearly this distinction between integral and non-integral investments will be subjective, which may limit comparability.
Not only are there differences between companies, but there can also be differences in the presentation of income from associates and joint ventures by the same company over time. A good example is French media conglomerate Vivendi. The company has a portfolio of unconsolidated equity investments, some of which are equity accounted associates, while others are reported at fair value with changes in fair value reported either in profit and loss or in OCI. Having so many different approaches to accounting for equity investments is itself confusing, and a subject we addressed (in part) in our article Ignore this ‘recycled’ profit – Ping An .
Vivendi’s most significant investment is its 17% stake in Telecom Italia (representing 24% of the voting rights). As it has significant influence over Telecom Italia, Vivendi has applied equity accounting ever since acquiring the stake in 2015. Initially it presented its share of net profit above the operating profit line as ‘Income from equity affiliates’. However, during 2018, there were changes to the governance structure of Telecom Italia that resulted in a decrease of Vivendi’s influence over Telecom Italia’s Board of Directors. Vivendi continued to exercise significant influence and hence apply equity accounting, but it changed the presentation in the income statement.
From 2018 Vivendi has split its income from equity affiliates into two categories: “Earnings from equity affiliates – operational” presented above the EBIT subtotal and “Earnings from equity affiliates – non- operational” presented below. The earnings contribution from its stake in Telecom Italia was moved to below the EBIT line in 2018. Vivendi’s split in the presentation of income from equity affiliates between operational and non-operational is similar to the IASB proposal, except that the criteria that it seems to apply are different. The IASB approach is to consider the relationship between the group and the associate and the degree of business integration. Vivendi, on the other hand, seems to be more focused on the level of influence, although this is not entirely clear.
Vivendi income statement presentation
Another interesting element worth highlighting is that, in 2018, Vivendi took a €1,066m impairment charge for its investment in Telecom Italia and presented this in other financial charges. After the impairment the carrying value of its stake in Telecom Italia was €3,130m, compared with a market value of €1,759m at year end 2018. This prompts questions about the adequacy of impairment charges and whether the equity method of accounting provides investors with the best information about these investments in the first place. For the new non-integral category, in particular, we think that fair value would be a better measurement basis.
Will integral and non-integral help investors?
Splitting associates between integral and non-integral does not really change anything other than having the classification itself and an additional sub-total in profit and loss. However, we think it would be useful for investors in both understanding the role of the associates and joint ventures within the overall business model and in helping investors to identify where their analysis is best focused on ‘flows’ rather than ‘value’.
We have previously argued that associates should be dealt with like other investments in enterprise value multiples – see our article ‘Enterprise value: Calculation and mis-calculation’. This means using a ‘operating’ enterprise value, which includes a deduction for the fair value of associates, combined with a profit metric that excludes any associate or joint venture income.
But the problem with this approach is that it requires the separate valuation of the associates, something that can be challenging, particularly for integral associates. Using a multiple that is based on integral associates being part of enterprise value (i.e. not deducting the associates from EV) may be easier and more relevant. For integral associates there must be a degree of interdependency between the group and associates, with potentially the operating performance of the group being affected.
The downside to this is that, because equity accounting represents an ‘equity’ flow, any multiple that includes the contribution from associates is a mixed multiple, combining both enterprise and equity elements. You could make adjustments to correct for this but, given the limited disclosures provided, you would probably need to examine the separate financial statements of the associates themselves. This might only be worth the effort if the associates were particularly significant or particularly integrated.
A similar challenge also applies to DCF analysis. It may be desirable to include the cash flows of integral associates in the enterprise free cash flow that is discounted given the interdependencies with the rest of the business. But, as for valuation multiples, you would need to be careful to ensure that this is done in a consistent manner.
Our view on the IASB proposals
We support the IASB’s proposals. We like the classification of financing, investing and operating items and mandating clearly defined subtotals. The approach is consistent with how investors generally analyse financial statements and with the use of enterprise value-based valuation techniques. The proposals would also end the current variation in the presentation of income from investments in associates and joint ventures. We are broadly supportive of the integral and non-integral split as we think that it would provide investors with additional information about the underlying business model, give the opportunity to analyse the different categories separately and, potentially, include each category differently in valuation models. However, we question if the classification of these investments, as currently articulated, will be comparable between companies.
Insights for investors
- Be careful when analysing companies with material associates and joint ventures. Make sure that profit margin and return on capital measures are not distorted.
- The IASB’s proposed changes to the presentation of the income statement will provide much needed comparability to operating profit and other sub-totals and consistency in the presentation of the income from associates.
- The proposed classification of associates as either integral or non-integral should provide useful information for investors on the company but also in comparing the company with its peers (as long as there is a reasonable amount of comparability in how this classifiation is done).
- Think about what is the best way to analyse associates and joint ventures. Is it the flows and operating performance that matters or should they simply be regarded as investments and not analysed in conjunction with other group operating activities?
- Unless there is a good reason not to, we think that associates and joint ventures accounted for under the equity method should be regarded as non-core assets for the purpose of enterprise value and EV based valuations.
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