IFRS 18 needs to deliver

My overwhelming reaction to the proposed IFRS 18, Presentation and Disclosure in Financial Statements, is ‘What took you so long?’ This is, I think, the first time that a new standard has been primarily aimed at making accounts more useful for users. I wholeheartedly welcome this approach, even though it is decades overdue.

Current IFRS Standards are riddled with flaws from an investor’s perspective. Possibly the only number that is widely trusted is revenue; virtually every other number has to be adjusted to make it meaningful.

I think it reflects poorly on the International Accounting Standards Board (IASB) that we have got to this stage. There has been far too much focus on tidying up and not nearly enough on what users really want.

Missing numbers

One of the inevitable consequences of this divergence is an explosion of non-GAAP metrics to help investors assess performance. Take almost any company in almost any sector and you will find that most of the numbers that investors watch are absent from the standards.

The absentees include organic growth, EBITDA, EBIT, net debt, return on capital, profit before amortisation of intangibles created during acquisitions, free cashflow and many more. This is not just unfortunate; it has an adverse impact on market efficiency.

Worse still, many of the non-GAAP metrics are impossible to derive from the audited accounts. This creates an obvious loophole for the small minority of managers who seek to overstate performance.

I used to follow one company that regarded sales from a new product as organic growth but did not treat lost sales from a discontinued product line as organic shrinkage. The only clue to this selective treatment was suspiciously high organic growth relative to its peers.

Definitive moment

I applaud the requirement to reconcile management metrics to the audited numbers. Some companies already do this, but it is not widespread. This should, if implemented properly, greatly increase investors’ confidence in management commentary. Many commonly used metrics lack a single widely accepted definition, and this change is potentially very significant. A sensible and common definition of free cashflow, for example, would be very welcome.

I am also delighted to see that we will at last have an audited operating profit (aka earnings before interest and tax or EBIT) number. It is difficult to overstate the importance of EBIT to investors.

Operating profits are a proxy for two crucial factors: how much a company’s output is valued by its customers (pricing) and how efficiently it can deliver that output (costs). Almost every investor I have met treated operating profits as entirely different from financing costs or income. Financing costs are just a reflection of the capital structure and can change overnight.

Still flawed

The new standard still has flaws, notably that operating profit will be after amortisation of intangible assets created out of thin air after an acquisition. I have presented to thousands of investors, and I only ever met one that regarded this as an operating cost. To me, it is just selective goodwill amortisation by the backdoor and hopefully it will be easy to back out.

It is important to stress the caveat ‘if implemented properly’. IFRS now requires the reconciliation of opening and closing net debt, but this welcome (and long overdue) improvement was implemented poorly. The sad outcome was that the IASB snatched defeat from the jaws of victory. Many companies have complied with the letter of the new rule without providing the information that investors need.

I worry that the initial implementation of IFRS 18 will underwhelm, rather like net debt reconciliation and key audit matters. It is up to both the IASB and the audit profession to ensure that this important initiative delivers on its potential.