Why IFRS 18 is good news for investors

Last updated 9 April 2024

The IASB has issued its new international standard for the presentation of financial statements – IFRS 18. Changes that will benefit investors include a prescribed operating-investing-financing structure for the income statement, new defined subtotals, additional disaggregation, and a more relevant cash flow presentation.

IFRS 18 will better align financial reporting with equity analysis and provide additional and more comparable data to facilitate that analysis, including data that should help investors to forecast performance and assess risk.

The IASB’s newly issued standard IFRS 18 mainly deals with the presentation of the income statement, balance sheet and certain footnotes. At the same time, certain aspects of the cash flow statement are modified. IFRS 18 does not change the recognition and measurement of the components of financial statements; therefore, the amounts reported as shareholders’ equity and net income are both unchanged. However, it will have a significant impact on the presentation and disaggregation of what is reported (primarily in the income statement and footnotes), including what subtotals companies must provide and how these are defined.

Article update 9 April 2023

The IASB has now published IFRS 18. Although we initially wrote this article prior to the standard being finalised, our comments and analysis remain valid. You can access all of the IASB’s documents here, including the full text of IFRS 18 and a non-technical summary.

More comparable and more relevant financial statement data for investors

We welcome the new standard and believe that it will result in more comparable and relevant information, more understandable financial statements, and financial data that is presented in a manner that more closely reflects how it is typically used by investors. You will have to wait for the full benefit to come through – the new standard will only be mandatory from 2027; however, we anticipate many companies will start to align with IFRS 18 sooner than that.

There are five main areas where we think the new standard will help investors:

Operating–Investing–Financing classification

Under IFRS 18, all companies will present separate categories of income and expense for operating, investing and financing activities. This is in addition to the existing discontinued-activities and taxation classifications in the income statement. There will be required subtotals following each of the new categories such that, for the first time, IFRS reporters must provide a measure of operating profit and profit before financing (equivalent to the commonly quoted EBIT). Although a not a required disclosure, there will also be a defined ‘specified subtotal’ of the profit before financing, tax, depreciation and amortisation – effectively EBITDA, even though that acronym is not used.

Income and expense from investing activities is defined as that arising from investments where gains and losses are largely independent of other activities, unlike the integrated nature of operating activities. Investing also includes income from all equity accounted investments in associates and joint ventures. Financing activities not only includes interest expense arising from financing obligations, but also interest accretion amounts from other liabilities measured on a present value basis, such as pension and other provisions. Of course, the IFRS requirements are much more detailed than this, but you will get the picture.

IFRS 18 will result in greater consistency and additional subtotals

Although many companies already separate investing and financing items in profit and loss, there is often little consistency in how these are presented and where subtotals are struck. The new format should provide you with a much more consistent presentation.

The IASB has used the following diagram to illustrate the possible changes to the presentation of certain income and expense items that could result.

Income statement effects of the new IFRS 18 presentation format

IASB presentation to their Emerging Economies Group

Why the operating-investing-financing classification will be good for investors

The new structure for the income statement better aligns with the typical enterprise value based approach to equity analysis and valuation that we advocate1See for example our article ‘Enterprise value: Our preference for valuation multiples’. and commonly used by investors. The operating section will more clearly provide the data needed for enterprise value multiples and form the basis for free cash flow in enterprise FCF based discounted cash flow analysis. Gains and losses classified as investing or financing relate to assets and liabilities whose fair value is best separately incorporated into market based enterprise value metrics used in valuation multiples, and in the enterprise to equity bridge in DCF analysis.

Post IFRS 18, it may well make sense for investors to adjust their approach to enterprise value to align with the new structure, such as including pensions in EV (if you are not already doing so) and treating associates as investments and not as a component of operating activities.

The treatment of associates is challenging, and we note that the IASB originally proposed a split of these into ‘integral’ (closer to operating activities) and ‘non-integral’ (classified as investments). We rather liked this approach and supported it in our comment letter on the IASB’s earlier exposure draft, even though we recognised the practical difficulties. Overall, the classification of all associates as part of investing activities, as will be the case in IFRS 18, will end the existing diversity in presentation and is helpful for investors.2We have previously argued that all investments in associates should be measured at fair value and treated like other minority equity investments. We think that fair value measurement combined with supplementary disclosures would provide a better basis for analysis compared with the existing equity accounting. See our article ’No insight for investors from equity accounting’.

Operating-investing-financing format will not apply to the balance sheet

Several years ago, the IASB considered applying the same operating-investing-financing structure to the balance sheet, with a principle of ‘cohesiveness’ applied across the primary statements. Such an approach has a lot of appeal for equity analysis, not least because it would make it easier to derive ratios such as return on invested capital. 

Ultimately, cohesiveness proved too challenging, and IFRS 18 will not result in any significant changes to the structure of the balance sheet. Nevertheless, we hope that companies will separately present balance sheet items that are linked to gains and losses presented differently in profit and loss, even if they cannot organise the balance sheet based on the same categories. The principles of disaggregation we explain below also apply to the balance sheet and, we would argue, that one of the ‘characteristics’ that should be considered for balance sheet disaggregation is the classification of the related income statement items.

Defined operating profit

While many companies currently provide a measure of operating profit, there is no clear definition of this subtotal in IFRS; what might appear to be comparable measures may, in practice, be defined quite differently. For example, operating profit measures may currently include interest expense items that other companies include in financing, and practice varies whether or not income from associates is included. The treatment of exchange differences is another area that creates inconsistencies.

Operating profit is a company’s main business activity plus anything else not investing or financing

IFRS 18 does not directly define operating profit but instead defines what should be classified as investing and financing, with everything else (other than taxation and discontinued activities) classified as operating. Nevertheless, operating is described as a company’s “main business activities”. We think this approach works well and is consistent with how investors regard this important measure of performance. Defining operating as a residual also ensures that management are not able to exclude from operating profit the inconvenient ‘other’ items (usually more other expenses than other income) that they may not wish investors to focus on too closely.

One of the challenges in specifying the presentation and classification of profit is how to deal with those financial companies for which interest income and expense or investment income is their main business activity. In this case, IFRS 18 requires that interest and investment income (that would be reported as investing and financing by non-financial companies) are instead reported as components of operating activities. As a result, the performance reporting by banks and insurers will be largely unchanged.

Why defining operating profit will be good for investors

Operating profit is a key metric for investors. It is used in equity analysis, such as in profit margin and return on invested capital measures, and in equity valuation as part of enterprise value multiples and in deriving enterprise free cash flow for DCF analysis. The greater comparability of operating profit under IFRS 18 (and in some cases the reporting of this subtotal for the first time) should improve the relevance of these analytical measures.

However, remember that any change in a company’s definition of operating profit may require you to change your calculation of other metrics. For example, in return on invested capital measures, it is important that the profit and invested capital components are consistent. If income from associates was previously included in operating profit, the balance sheet value of associates should be included in invested capital (i.e. not deducting associates from invested capital). Under IFRS 18 operating profit will exclude income from associates and, therefore, you should similarly exclude the investment in associates from the invested capital component of ROIC.3We would recommend not including associates in ROIC anyway even under current accounting presentation. The share of associate profit is post-interest and post-tax, and combining this with operating profit produces an overall return on capital measure that is difficult to interpret.

We also like the new definition of a metric equivalent to EBITDA. This is not a required disclosure under IFRS 18 but rather a ‘specified subtotal’ meaning that, if disclosed, there will be a common definition. This measure is often used by investors (in fact over-used in our view4For example, see the discussion about the use of EBITDA in our article ‘EBITDA-AL: More letters but no more insight’.) and at present EBITDA can be presented quite differently. Some companies and investors make additional ‘non-cash’ adjustments beyond depreciation and amortisation, and there are different approaches to adjusting for ‘exceptional’ items. While ‘EBITDA’ will likely still be adjusted post IFRS 18, there should at least be a common starting point.

Many companies are likely to be affected by the new prescribed structure of the income statement, including our example below, Air France-KLM:

Air France-KLM income statement extract

Air France-KLM 2023 financial statements

Although Air France KLM currently provides an operating profit measure, this is likely to change after IFRS 18 is implemented. For example, at present the interest expense relating to defined benefit pension plans is included in operating results, whereas under IFRS 18 this must be part of financing. The change will enhance comparability with those companies that already chose to present this item in financing, such as competitor airline IAG. Interestingly, other subtotals are presented in the operating section above. This will still be permitted under IFRS 18 (subject to certain restrictions).

Another change to the above prompted by IFRS 18 will be the separation of investing and financing, and the presentation of income from associates as part of investing. Air France-KLM currently applies a relatively unusual approach of showing associates below taxation. All these changes will help in ensuring greater comparability.

Disaggregation and the end of other income and expense

IFRS 18 will introduce new guidance regarding when additional disaggregation is needed for items presented on the face of the primary financial statements or in the footnotes. The standard will also mandate meaningful descriptions for line items, which is not always the case at present – no more income or expenses confusingly labelled as “other”.

A single difference in underlying characteristics will require disaggregation and separate presentation or disclosure

The disaggregation principles in IFRS 18 are based on identifying whether items have similar or dissimilar characteristics, such how items vary in response to external economic factors, whether an item is non-recurring, or whether it represents a change in value rather than a current period flow. Importantly, just one different characteristic will result in companies being required to present an item separately from others – in other words disaggregated.

IFRS 18 will maintain the existing option to present expense items on the face of the income statement using a ‘by-function’ analysis (cost of sales, admin expenses, etc) or a ‘by-nature’ analysis (materials, employee benefits, depreciation, etc). However, there will be a new requirement to provide more detailed by-nature expense disaggregation in the notes.

Why the new disaggregation requirements will be good for investors

In our view, if applied correctly by companies and enforced well by auditors and regulators, the new disaggregation requirements should significantly enhance investor understanding, particularly of performance measures. While at present there is significant disaggregation of income and expense items in both the income statement and supporting footnotes, in our view this does not always go far enough, as we explain in our article ‘Disaggregation is key to understanding performance’.

The separate disclosure of expenses where their nature and underlying economic drivers differ should also enhance the ability of investors to forecast. For example, in the case of Air France-KLM, the company already gives a useful breakdown of expenses that goes beyond what is currently required by IFRS, including the separate disclosure of aircraft fuel expense, where there is clearly different underlying economic drivers.

Air France-KLM expense disaggregation disclosure

Air France-KLM 2023 financial statements note 7

We also think that better disaggregation will help in assessing operating risks. While there is no requirement for financial statements to disclose operating leverage, greater disaggregation should help investors better understand the relationship between changes in revenues and operating profit. Furthermore, the risks associated with, and generated by, investing and financing decisions are very different from those arising from operating activities. Having this categorisation in addition to additional disaggregation should further enhance the ability of investors to understand and forecast risk.

Management performance measures

IFRS will bring existing non-IFRS (non-GAAP) ‘management’ performance measures into the audited financial statements. Companies will be required to explain these metrics in a separate footnote and provide a reconciliation to an appropriate IFRS defined performance measure, such as operating profit or net income.

In practice, you may not see much change considering that most companies already provide detailed reconciliations of their adjusted metrics, as required by securities regulation. However, these disclosures will no longer be outside the financial statements.

Additional disclosures of the tax and NCI impact of adjustments to management performance measures

There is some additional disclosure required by IFRS 18 which may help investors, including a requirement to identify the tax and non-controlling interest impact of each item excluded from any management performance measure. At present this is often done in aggregate, and only if an adjusted earnings measure is provided.

Why management performance measure disclosures will be good for investors

Bringing these measures into the scope of IFRS is welcome and will add an additional layer of discipline into a challenging area for investors. Furthermore, the additional tax and NCI disclosures will be particularly useful for investors who wish to make their own adjustments to net income. One word of caution when using this data, IFRS 18 permits companies to apply different approaches to determining the tax effect of adjusting items.

We have previously argued that non-GAAP measures can be very helpful. It is not so much the metrics themselves that are useful but rather that the additional disaggregation is particularly helpful for investors. Companies often exclude expense items that most investors would regard as an integral component of performance, such as employee share-based remuneration, so being able to easily adjust the management figure is important.

Operating cash flow

IFRS 18 does not itself deal with the format of cash flow statements. However, the IASB is also making some limited amendments to IAS 7 to address some existing presentational inconsistencies.

At present, IFRS reporters have flexibility over where they present interest expense and dividend income – either in or outside the operating category – which has led to a lack of comparability of cash flow subtotals. The new requirement is that both these items must be reported outside of the operating activity section of the cash flow statement in either investing or financing, as appropriate.

The other main change is that the calculation of operating cash flow (when presented using the indirect method5The indirect method is where operating cash flow is derived from profit by removing non-cash items including depreciation and the effects of accruals accounting such as those reflected in changes in working capital.) must start with the newly defined operating profit. At present companies start the calculation with a variety of profit measures, including operating profit, pre-tax profit and net income.

Why the changes to the cash flow statement will be good for investors

A different starting point for indirect operating cash flow reconciliation does not itself affect the final operating cash flow measure, considering that the subsequent addbacks differ. However, in our experience, the differences in presentation currently seen in practice are highly confusing for investors. Having a common starting point, plus the greater comparability achieved by removing presentation options, means that cash flow data will become more relevant and understandable, particularly the operating cash flow metric.

Operating cash flow is not exactly the cash equivalent of operating profit

However, an important potential confusion still applies, which is the operating-financing-investing categorisation. This terminology is already used for the cash flow statement and, unfortunately, the new application of these labels in the income statement is not entirely the same. The key difference is the treatment of capex – in cash flow statements this is part of investing cash flow but the equivalent (accruals accounting) income statement impact, in the form of depreciation and amortisation, is included in operating profit. Furthermore, the operating cash flow is post-tax, but operating profit is pre-tax.

While the current amendments to cash flow statements are welcome, there are other aspects of cash flow reporting that we think should be considered by the IASB. One area we have mentioned many times in our articles6See for example the effective flows arising from leasing transactions described in ‘DCF valuation models: Have you updated for IFRS 16?’ and supply chain financing transactions described in ‘New supplier finance disclosures will affect operating cash flow’. is the disclosure of non-cash transactions which comprise offsetting ‘effective flows’, as we call them. Those investors that understand the issue can make adjustments based on existing disclosures, but it would help all investors if the presentation of these items is improved.

The IASB is already conducting a wider investigation into cash flow reporting so, hopefully, we can look forward to further improvements in the future.

Insights for investors

  • IFRS 18 will not result in changes in assets and liabilities or the measurement of shareholders’ equity and net income. However, key profit and loss subtotals may be impacted, especially operating profit.
  • IFRS 18 will improve comparability through a new operating-investing-financing classification and through definitions of operating profit and operating profit before depreciation and amortisation (effectively EBITDA).
  • IFRS 18 will result in greater disaggregation in the primary financial statements and notes due to new principles and new requirements for disclosure of expenses ‘by-nature’.
  • Greater consistency of presentation and additional disaggregation under IFRS 18 will help investors to understand and forecast performance metrics.
  • The limited changes to the cash flow statement will make operating cash flow more comparable and the indirect reconciliation less confusing.

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