John Hughes

Gross margin – an inappropriate omission?

Wednesday, November 20, 2013 by John Hughes

 

As part of its activities, the European Securities and Markets Authority (ESMA) organizes a forum of enforcers from 30 different European jurisdictions, all of whom carry out monitoring and review programs similar to those carried out here by the Canadian Securities Administrators. ESMA recently published some extracts from its confidential database of enforcement decisions on financial statements, covering twelve cases between July 2012 and March 2013. These extracts aim to provide, “issuers and users of financial statements with relevant information on the appropriate application of IFRS.” There’s no way of knowing whether these are purely one-off issues or more widespread, but some of them certainly are relevant to matters occasionally discussed within Canadian entities.

One of these extracts is as follows:

“During 2011, the issuer acquired a major business. The inventories acquired in this business combination were valued at their acquisition-date fair value in accordance with paragraph 18 of IFRS 3, causing a fair value step-up. An important part of the acquired inventories were sold in 2011.

In the income statement, the cost of inventories acquired in the business combination and sold by the acquirer after the business combination was split on two different lines, partly as cost of goods sold and partly as a ‘non-recurring item’ within operating income. The part presented under cost of goods sold corresponds to the carrying amount of those inventories in the acquiree's financial statements. The part presented as a non-recurring item corresponded to the fair value step-up recognized as part of the measurement of the business combination and amounted to 30% of the issuer's EBIT. The non-recurring item was explained in the notes to the financial statements.

The issuer underlined the fact that revaluing inventories at fair value would result in a fall in the issuer's gross margin due to the fair value step-up. The issuer argued that isolating this part of the margin in the non-recurring items, whose nature is transparently presented in the notes, enabled the user to evaluate the structural evolution of its gross margin.”

The issuer also argued that IFRS concepts of cost of sales and gross margin and its requirements for classifying expenses in the income statement are sufficiently vague to allow room for this particular manoeuvre, as long as everything’s clear in the notes. Certainly, we can agree that this is better than not disclosing the matter at all. Still, the enforcer (as the report likes to put it, as if relishing the Eastwoodian connotations) disagreed and concluded the entire amount should have been classified as cost of sales.

What is cost of sales?

There’s a bit of a shortcut in ESMA’s explanation of this conclusion. It says among other things: “Paragraph 38 of IAS 2 defines cost of sales as costs previously included in the measurement of inventory that has now been sold and unallocated production overheads and abnormal amounts of production costs of inventories.”

That’s not quite accurate though: IAS 2.38 actually says: “The amount of inventories recognized as an expense during the period, which is often referred to as cost of sales*, consists of those costs previously included in the measurement of inventory (and so forth)” (*my emphasis). Saying something is “often referred to” as cost of sales doesn’t quite amount to locking that down as a definition, or to precluding other treatments of it. Similarly, the explanation cites the IAS 2.34 requirement that “when inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the period in which the related revenue is recognized.” But the reference to being “recognized as an expense” doesn’t seem to preclude the possibility of analyzing that expense into more than one line, if considered relevant to an understanding of the entity’s financial performance.

I think the real point should be this: if you’re going to hold out a widely-understood measure of core operating performance like gross margin, then you can’t play with the prevailing expectations for what it includes or excludes. The report doesn’t cite the following passage from the basis of conclusions to IAS 1: "The Board recognizes that an entity may elect to disclose the results of operating activities, or a similar line item, even though this term is not defined. In such cases, the Board notes that the entity should ensure that the amount disclosed is representative of activities that would normally be regarded as ‘operating’. In the Board's view, it would be misleading and would impair the comparability of financial statements if items of an operating nature were excluded from the results of operating activities, even if that had been industry practice. For example, it would be inappropriate to exclude items clearly related to operations (such as inventory write-downs and restructuring and relocation expenses) because they occur irregularly or infrequently or are unusual in amount.” (Canadian regulators have also cited this passage in the past).

In this case, the carrying amount of the inventories in the acquiree’s previous financial statements simply wasn’t relevant, once the issuer paid more than that to acquire them and recorded them accordingly. Inventories of a similar nature may perhaps be acquired on a variety of different terms and conditions, depending on bargaining power and other circumstances, but once you’ve acquired them, then the process of turning them into revenue is all the same thing and thus inextricable from your core measure of operating performance. It’s certainly important that investors understand the impact of unusual or non-recurring influences on this measure, but as in many other areas of accounting, the goal of promoting clarity and understanding doesn’t provide a rationale for overturning rational and consistent presentation in the statements.

So that’s one of the ESMA issues – I’ll deal with some of the others in future posts.

The opinions expressed are solely those of the author

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