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Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

CA Bhawna Grover Manager - Research and Advisory, Taxmann

CA Prajwal Jha Associate - Research and Advisory, Taxmann

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

CA Bhawna Grover Manager - Research and Advisory, Taxmann

CA Prajwal Jha Associate - Research and Advisory, Taxmann

Contents 1.

Introduction

2. Presentation of Operating Expenses

What does Presentation by Nature Mean?

4. What does Presentation by Function Mean?

Is it a free choice between Nature and Function?

6. Can an entity use both Nature and Function?

What if Nature and Function are mixed?

8. Special requirements when expenses are presented by Function

9. Additional Disclosure of Nature-based Expenses

10. Aggregation of Operating Expenses

11. Conclusion

Introduction

The classification of income and expenses into five categories is one of the key changes proposed by Ind AS 118, Presentation and Disclosure in Financial Statements. However, determining that an expense belongs to the operating category is only the first step. The next question is how those operating expenses should be presented in the statement of profit and loss. Under the existing requirements, entities following Ind AS 1, Presentation of Financial Statements generally present an analysis of expenses recognised in profit or loss based on their nature. The Exposure Draft of Ind AS 118, proposes a different approach. It requires an entity to present operating expenses in a manner that provides the most useful structured summary of its expenses, using the characteristics of nature, function, or both. Therefore, the proposed requirements do not simply provide an unrestricted choice between nature-wise and function-wise presentation. The entity is required to assess which approach provides the most useful information to users, considering factors such as the drivers of profitability, the manner in which the business is managed, industry practice and whether allocation of expenses to functions would be arbitrary. This article examines the proposed requirements relating specifically to the presentation of operating expenses, including nature-wise presentation, function-wise presentation and the circumstances in which a mixed presentation may be appropriate.

2. Presentation of Operating Expenses Ind AS 118 requires an entity to classify and present expenses in the operating category in line items in a manner that provides the most useful structured summary of its expenses. For this purpose, an entity uses one or both of the following characteristics: a)

nature of expenses or

function of expenses within the entity.

The requirement is therefore based on the usefulness of the information presented rather than prescribing one particular basis for all entities. Further, it clarifies that an individual line item should comprise operating expenses aggregated on the basis of only one of these characteristics. However, the same characteristic need not necessarily be used as the basis for every line item. This creates the possibility of a mixed presentation, where some expenses are presented by nature and others by function. Accordingly, the presentation of operating expenses under Ind AS 118 can broadly take three forms: a)

presentation by nature;

presentation by function; or

a combination of nature and function.

The choice is, however, subject to the principles and factors prescribed by the Standard.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

3. What does Presentation by Nature Mean? When expenses are classified by nature, the entity presents information based on the type of economic resources consumed in carrying out its activities. It includes the following expenses: a)

raw material expenses

employee benefit expenses

depreciation and

amortisation

The classification does not consider the particular activity for which those resources were consumed. Instead, it focuses on what the entity has consumed in undertaking its activities. Illustration 1 – Nature-wise presentation Suppose a manufacturing entity incurs the following operating expenses: Particulars

Amount (₹ crore)

Raw materials

300

Employee benefits

100

Depreciation

Advertising

If the entity presents its operating expenses by nature, the statement of profit and loss may separately present these expenses as raw materials, employee benefits, depreciation and advertising. The focus is therefore on the nature of the resources consumed, rather than whether those resources were consumed in production, administration, selling or another function.

4. What does Presentation by Function Mean? Under a function-wise classification, operating expenses are allocated and aggregated according to the activity to which the consumed resources relate. For example, an entity may present: a)

cost of sales

distribution costs

administrative expenses and

research and development expenses.

A function line item can contain expenses of several different natures. For example, cost of sales could include raw material expenses, employee benefit expenses, depreciation and amortisation relating to production activities.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

At the same time, an expense of the same nature may be allocated across different functions. For instance, employee benefit expenses may be incurred by production employees, research personnel and administrative staff. Consequently, the same type of expense may form part of different function-based line items. Illustration 2 – Function-wise presentation Consider the following expenses of a manufacturing entity: Nature of expense

Production

Administration

Selling

Employee benefits

₹60 crore

₹15 crore

₹10 crore

Depreciation

₹25 crore

₹5 crore

₹2 crore

Raw materials

₹250 crore

Under function-wise presentation, these amounts may be aggregated into functionbased line items such as cost of sales, administrative expenses and selling expenses. Thus, unlike nature-wise presentation, function-wise presentation focuses on where or for what activity the resources were consumed. The Exposure Draft specifically explains that a function line item can combine expenses of different natures.

5. Is it a free choice between Nature and Function? Not entirely. This is one of the important aspects of the proposed requirements. Paragraph 78 of the Ind AS 118 requires the entity to present operating expenses in a manner that provides the most useful structured summary. Paragraph B80 further specifies the factors that an entity needs to consider when determining how the characteristics of nature and function should be used. The relevant factors to be considered in this regard include the following:

5.1 Main components or drivers of profitability The entity should consider which line items provide the most useful information about the important components or drivers of its profitability. For example, for a retailer, cost of sales may be an important driver of profitability. Presenting cost of sales separately could help users understand the relationship between revenue from sales and the related direct costs. In contrast, for certain service entities where the relationship between revenue and costs is less direct, information about expenses by nature, such as employee benefits, may provide more useful information because employee costs may be a major driver of profitability.

5.2 How the business is managed The entity should also consider how the business is managed and how management reports internally.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

For example, a manufacturing entity managed through major functions may find functionwise information more useful for internal reporting. On the other hand, an entity with a single predominant function may find nature-wise information more useful.

5.3 Standard industry practice Industry practice is another consideration. Where entities operating in the same industry classify expenses in a similar manner, users may find it easier to compare expenses across entities. Accordingly, the entity should consider the manner in which expenses are commonly presented within its industry

5.4 Whether allocation to functions would be arbitrary An entity should also consider whether particular expenses can be allocated to functions in a manner that faithfully represents the functions. If allocation of a particular expense to different functions would be arbitrary to such an extent that the resulting line items would not faithfully represent the functions, the entity is required to classify those expenses by nature.

6. Can an entity use both Nature and Function? Yes. Ind AS 118 specifically recognises circumstances where a combination of nature-wise and function-wise presentation may provide the most useful structured summary. For example, an entity may determine that most expenses should be presented by function because this provides better information about its profitability. However, allocation of certain expenses to functions may be arbitrary. Those particular expenses may therefore be presented by nature. Similarly, an entity having two different types of main business activities may determine that some expenses are more meaningfully presented by function, while others are more appropriately presented by nature. Illustration 3 – Mixed presentation Consider a company having two major business activities, manufacturing and providing specialised technical services. The company determines that function-wise presentation provides useful information for its manufacturing operations because cost of sales is a significant driver of profitability. However, certain employee-related expenses relating to its technical service activity cannot be allocated reliably between different functions without using arbitrary allocation bases. In such circumstances, the entity may present manufacturing-related expenses by function while presenting the relevant unallocated employee benefit expenses by nature, provided the resulting presentation meets the requirements of Ind AS 118. Thus, the proposed requirements do not require an entity to adopt one single basis for every operating expense.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

7. What if Nature and Function are mixed? Where an entity presents some expenses by nature and others by function, the labelling of line items becomes particularly important. Ind AS 118 requires the entity to label the resulting line items in a manner that clearly identifies the expenses included in each line item. For example, if some employee benefits are included in a function line item such as cost of sales while the remaining employee benefits are presented separately by nature, the nature-based line item should make it clear that it does not represent all employee benefits. This prevents users from incorrectly assuming that a line item represents the entire amount of an expense merely because it carries the name of that nature of expense.

8. Special requirements when expenses are presented by Function The use of function-wise presentation also brings additional presentation and disclosure requirements. Where an entity classifies operating expenses into functions that include a cost of sales function, paragraph 82 of Ind AS 118 requires the entity to present cost of sales as a separate line item. The cost of sales line item is required to include the total inventory expense described in paragraph 38 of Ind AS 2, Inventories. The entity must also provide a qualitative description of the nature of expenses included in each function line item. Therefore, function-wise presentation does not mean that users are deprived of information about the nature of expenses included within those functions.

9. Additional Disclosure of Nature-based Expenses Ind AS 118 further seeks to retain important information about the nature of expenses even where an entity uses function-wise presentation. Where an entity presents one or more function-based operating expense line items, paragraph 83 requires disclosure, in a single note, of specified expenses by nature, including: a)

depreciation;

amortisation;

employee benefits;

impairment losses and reversals of impairment losses; and

write-downs and reversals of write-downs of inventories.

The entity is also required to disclose, for each of these totals, the amount relating to each operating-category line item and identify any line items outside the operating category that also contain amounts relating to the relevant total.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

This requirement is significant because a function-wise statement of profit and loss could otherwise make it difficult for users to determine the total amount incurred on certain important types of expenses.

10. Aggregation of Operating Expenses The proposed requirements do not end with deciding whether an expense is presented by nature or function. The level of aggregation also needs to provide the most useful structured summary. Paragraph B85 explains that an entity should consider what level of aggregation of operating expenses provides the most useful structured summary. For example, an entity may have administrative activities such as: a)

human resources

information technology

legal and

accounting.

Since these activities involve resources consumed in administrative activities, the entity may aggregate them into a line item such as “administrative expenses”. However, selling expenses have a different characteristic because they relate to selling activities. If those characteristics are sufficiently dissimilar from administrative expenses, separate presentation of selling expenses and administrative expenses may be necessary. Thus, aggregation should not be used merely to reduce the number of line items. The resulting presentation must continue to provide meaningful information to users.

11. Conclusion The proposed Ind AS 118 requirements change the way entities approach the presentation of operating expenses. The focus is no longer merely on whether expenses are classified by nature or function. Instead, the entity must determine which presentation provides the most useful structured summary of its operating expenses. The assessment requires consideration of the entity’s profitability drivers, the manner in which its business is managed, industry practice and whether allocation of expenses to functions would be arbitrary. In appropriate circumstances, an entity may use a combination of nature-wise and function-wise presentation. At the same time, function-wise presentation is accompanied by additional disclosures to ensure that users continue to obtain information about significant expenses by nature. The requirements relating to labelling, aggregation and consistency further emphasise that the presentation should faithfully communicate the underlying characteristics of the expenses rather than merely follow a convenient format. Accordingly, the implementation of Ind AS 118 will require entities to reassess not only where an expense is classified, but also how the expense is presented and explained in the financial statements. This makes the presentation of operating expenses an important practical area in the transition to the proposed Standard.

Insights on Ind AS 118 Understanding the Nature-wise and Function-wise Presentation of Operating Expenses

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Taxmann's Analysis | Proposed Ind AS 118: Operating Expense Presentation