IFRS 18: how to classify income and expenses
Overview of IFRS 18 classification requirements
Classification based on main business activities
The classification of income and expenses in the statement of profit or loss is determined by your main business activities. This requires an assessment of whether investing in particular types of assets or providing financing to customers constitutes a main business activity.
Many entities carry out more than one main business activity. For example, a company that manufactures goods and offers financing to its customers, may determine that both are main business activities. When applying IFRS 18 to classify income and expenses as operating, investing or financing, a company must determine whether investing in assets or providing customer finance, or both, are core to its business. Income and expenses from these main activities are typically reported within the operating category.
This conclusion must be based on facts, rather than an assertion. It also needs to apply to the reporting entity as a whole. The assessment may differ between a consolidated group and one of its subsidiaries, as each might have distinct main business activities based on their specific roles
Once your main business activities have been established, there is specific guidance in IFRS 18 on the classification of foreign exchange gains and losses, gains and losses on derivatives and designated hedging instruments, and other gains and losses. You can learn more about what to report on where in our article, redefining the statement of profit and loss.
Classification of foreign exchange gains and loses
Under IFRS 18, foreign exchange gains and losses recognised under IAS 21 are classified in the same category as the income or expense items that gave rise to the foreign exchange difference. The exception to this is where doing so would cause undue cost or effort, which should be assessed on a case-by-case basis.
For instance, if a company has a receivable from the sale of goods or services in a foreign currency, any related foreign exchange gains or losses are classified in the operating category. On the other hand, if there is a foreign currency debt instrument that will be settled in cash, the resulting foreign exchange differences would typically fall under the financing category. Sometimes, a single transaction may result in amounts that belong to different categories, for example purchasing services in a foreign currency with extended payment terms. In these cases, the service expense is classified as operating, while the interest element arising from the extended payment terms is classified as financing.
It is up to management teams to judge which category to assign the foreign exchange gains or losses to, either the operating or financing category, but not both. This decision should be based on which element they relate to, rather than splitting them between categories.
For management reporting, the new classification requirements will mean more detailed analysis of the sources of foreign exchange movements is needed. Management teams must ensure that foreign exchange gains and losses are accurately categorised within the business’ chart of accounts, which will likely involve more effort and resources.
Overall, the impact on reporting is an increased focus on the accurate classification of foreign exchange gains and losses, with the aim of greater transparency and comparability between financial statements. This will help management and investors make better-informed decisions based on a clearer understanding of the entity's financial performance.
Classification of gains and losses on derivatives and designated hedging instruments
When it comes to fair value gains and losses on derivatives, classification depends on how the instruments are used and whether they are designated in a hedging relationship or otherwise used to manage specified risks.
For derivatives used for hedging or to manage specific risks, the gains and losses are presented within the same category as the associated income and expense impacted by the risks the instrument is intended to manage, unless doing so require the grossing up of gains or losses.
When a derivative is not specifically used to manage identified risks, any resulting gains or losses are typically classified within the financing category, if the derivative is connected to a transaction solely for raising finance. If not, its gains and losses should instead be reported in the operating category.
For hybrid contracts that feature a liability with an embedded derivative, such as a bank loan incorporating a prepayment option, the classification of income and expenses can be complex. It depends on whether the embedded derivative is separated from the host liability, as well as the overall nature of the contract. If the embedded derivative is accounted for separately, the relevant guidance for both liabilities and standalone derivatives should be applied independently. Where the embedded derivative is not separated from the host contract, the rules relating to income and expenses from liabilities generally take precedence.
Classification of other gains and losses
Other gains and losses from the derecognition of assets or liabilities should be categorised according to the classification of related income and expenses prior to their derecognition. For instance, gains or losses from the disposal of property, plant and equipment should be included in the operating category. In contrast, if an investment property that is not part of a main business activity is disposed, these amounts will usually be reported in the investing category.
Similarly, gains and losses from the derecognition of a liability are classified based on the underlying transaction. If a trade payable is derecognised as a result of a supplier finance arrangement, it is classified in the operating category; if it results exclusively from financing activities in a business that doesn’t provide financing to customers as a main business activity, it is classified within the financing category.
Preparing for the new classification requirements
It is essential to plan early for IFRS 18 to make sure your financial statements comply with the new requirements, including:
- Assessing your business’s primary activities and determining whether they align with one of the specified main business activities under IFRS 18.
- Reviewing your current income statement line items and aligning them with the new categories and required subtotals.
- Identifying any reclassifications needed to comply with the new requirements, particularly general ledger accounts that may need to be split into separate categories.
- Updating your systems, including Chart of Accounts, ERP and reporting templates to make sure that all presentation and disclosure requirements are met.
Getting ready for IFRS 18 classification changes
Implementing IFRS 18’s classification requirements for income, expenses, foreign exchange and derivatives can be complex. Our accounting and financial reporting specialists can help you assess your main business activities, review current classifications and update your systems to be compliant. Contact Tiaan Fourie, Lou Ward or your usual RSM adviser to discuss how we can guide your organisation through the transition to IFRS 18.