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Presenting the income statement · PwC's accounting podcast

0:00
SPEAKER_00: Thought Leadership from PWC.
0:06
SPEAKER_01: Welcome to PWC's Accounting Podcast.
0:09
SPEAKER_01: I'm Heather Horn.
0:11
SPEAKER_01: It's finally February, and for us accountants, February in general means reporting and earnings season.
0:18
SPEAKER_01: So to kick off this month of podcasts, we're going to focus on financial statement presentation.
0:24
SPEAKER_01: So there's no better time for a refresher on a topic that's fundamental to financial reporting.
0:30
SPEAKER_01: Income statement presentation and classification.
0:34
SPEAKER_01: So income statement presentation, including notably operating versus non-operating classification, continues to be a clear focus in the investor community and, of course, as a result of standard setters, as well as a frequent comment letter trend.
0:49
SPEAKER_01: So we're here to discuss why.
0:52
SPEAKER_02: It also, therefore, does tend to be something that tends to attract SEC comments, particularly as it relates to the classification of expenses on the income statement, whether those are cost of sales or some other expense, whether perhaps they're operating or non-operating.
1:10
SPEAKER_02: So that's probably the reason why it continues to be a point of focus.
1:14
SPEAKER_02: The other thing, in spite of all those reasons why this is such an important statement, there really isn't a lot of authoritative literature that provides a lot of prescription around how you should prepare the statement.
1:27
SPEAKER_02: I think that's where then you tend to see judgment being applied, you tend to see maybe some diversity in practice, and that sort of drives questions.
1:35
SPEAKER_03: Article 5 does tells you that if you have to break down the revenues in different line items, you will only have to then show the cost of sales related to those items as well.
1:44
SPEAKER_03: Other operating expenses, they do just provide like a broad guidance that just says disclose separately if the amounts are material, so that provides more judgment for registration determining if there is something else beyond those other items to break out in the blue statements.
2:08
SPEAKER_01: That was Pat Durbin, a deputy chief accountant in PwC's national office, and Felix Perez, a partner in PwC's national office who specializes in SEC reporting.
2:18
SPEAKER_01: The two of them came together to help us understand income statement classification and to share insights on the key areas of judgment and practical tips and considerations for financial services compared to other sectors.
2:31
SPEAKER_01: They also are going to give us some updates on the DICE project, so stay tuned for that.
2:37
SPEAKER_01: They have a lot to cover, so let's get started.
2:40
SPEAKER_01: Pat Felix, thanks so much for joining me today as we continue our focus on financial reporting hot topics.
2:47
SPEAKER_01: And this week we're diving into one of the more popular topics we see when it comes to financial statement presentation, and that would be income statement classification.
2:56
SPEAKER_01: So maybe to kick things off, Pat, can you help us uh with some insight in terms of why this is such a hot topic?
3:04
SPEAKER_02: Well, I think um the income statement is fundamental to financial reporting, right?
3:08
SPEAKER_02: It's um really the the statement where the entity's performance is measured, is portrayed to the investors.
3:17
SPEAKER_02: It drives EPS, it sort of drives EBITDA.
3:21
SPEAKER_02: Those are both key metrics that investors will look at when they're thinking about equity valuations.
3:26
SPEAKER_02: Um clearly it's something that investors are always asking about questions on on the income statement and um you know, in sort of earnings calls, et cetera.
3:35
SPEAKER_02: And probably really for people outside of the preparation of financial statements, is probably the thing that gets the most focus by the user community because it it really does uh describe the company's performance.
3:49
SPEAKER_02: It also, therefore, does tend to be something that tends to attract SEC comments, particularly as it relates to the classification of expenses on the income statement, whether those are cost of sales or some other expense, whether perhaps they're operating or non-operating.
4:07
SPEAKER_02: So that's probably the reason why it continues to be a point of focus.
4:11
SPEAKER_02: The other thing, in spite of all those reasons why this is such an important statement, there really isn't a lot of authoritative literature that provides a lot of prescription around how you should prepare the statement.
4:23
SPEAKER_02: And I think that's where then you tend to see judgment being applied, you tend to see maybe some diversity in practice, and that sort of drives questions.
4:31
SPEAKER_01: Yeah, it's interesting to that point, Pat.
4:33
SPEAKER_01: I was thinking when you made your first comment, it's a key part of the financial statements.
4:37
SPEAKER_01: I mean, I think we only have four statements, if I'm counting right.
4:40
SPEAKER_01: Three or four topics.
4:40
SPEAKER_01: Yeah, three, depending on how you do them.
4:42
SPEAKER_01: So at a minimum, it's like a quarter.
4:44
SPEAKER_01: But even with that said, to the point you made, I think cash flow is the other one where we tend to get a lot of questions, but there is guidance on that.
4:53
SPEAKER_01: And every year, that's actually our most popular podcast.
4:57
SPEAKER_01: But I actually can't think of when we really talked about this topic on the podcast.
5:01
SPEAKER_01: And I think it is because there's a lot of industry practice and things that have grown up, but it's not like you can open an ASC and say, oh, you know, here's what I need to point to.
5:10
SPEAKER_01: But one of the things you mentioned that I think is very important there is sort of the interaction with non-gap, because I think for a lot of companies, they actually probably are focusing, I don't want to say more, but a lot on their non-gap measures in addition to the income statement.
5:25
SPEAKER_01: So I know, Felix, you just finished previewing uh lots and lots of SEC filings.
5:32
SPEAKER_01: So can you give us a little bit of color in terms of interaction of the income statement with the non-gap metrics and you know some of the issues we see?
5:41
SPEAKER_03: Happy to, Heather.
5:42
SPEAKER_03: As you mentioned, we can't ignore the interaction between the income statement and non-GAAP.
5:48
SPEAKER_03: The main reason is because the non-GAP measures, or the majority of them, are derived from a measure or a number that comes from the income statement.
5:55
SPEAKER_03: So the registrants are required on the regulation G to reconcile the non-gap measures to the closest comparable gap metric, and that tends to be one that it's based out of the income statement.
6:06
SPEAKER_03: Companies are also using non-gap metrics to provide investor useful information, but the SEC has a number of rules on how to do that.
6:14
SPEAKER_03: There's a podcast that we we have on non-GAP metrics, so that provides a lot of the context and guidance.
6:20
SPEAKER_03: However, one thing we've seen the SEC recently zero in on what car registrants are doing, is the nature of the adjustments, particularly in terms of whether it's a recurring cash operating expense that is being adjusted out of an income statement metric to arrive at a non-gap metric.
6:36
SPEAKER_03: And it is that interaction that, depending on you how you classify it, may result in an SEC comment from the SEC.
6:42
SPEAKER_03: The income statement, as you know, it's the objective measure of the company's performance.
6:49
SPEAKER_03: And therefore, it provides the investors an insight into the ability to generate future cash flow.
6:54
SPEAKER_03: So investors are using it to estimate the company fair value, like Pat mentioned.
6:58
SPEAKER_03: And in terms of the podcast, our our hope is that we'll be providing some key reminders as registrants start their fiscal year 2024 reporting article.
7:07
SPEAKER_01: Yeah, although it is interesting as you say, you know, investor useful information.
7:11
SPEAKER_01: I think then we always get that question well, shouldn't the gap financial statements be providing that information?
7:17
SPEAKER_01: So I know we're gonna get to the DICE project.
7:19
SPEAKER_01: So hopefully that will, I'll say, close some of those gaps, not to make a play on word there.
7:26
SPEAKER_01: Uh but anyway, with sort of all the background, and I don't I don't know that we needed to convince the audience that this is important.
7:33
SPEAKER_01: But Pat, maybe we can just start by level setting.
7:36
SPEAKER_01: And notwithstanding the fact we said there's you know not a ton of guidance here, there are some sort of basic line items that are expected.
7:44
SPEAKER_01: So can you run through those?
7:46
SPEAKER_02: Yeah, and so maybe, and you alluded to it at the beginning, just in terms of what we call the statement.
7:50
SPEAKER_02: So formally it's called the income statement.
7:53
SPEAKER_02: Um sometimes you'll see it referred to as the statement of operations, statement of comprehensive income.
7:59
SPEAKER_02: Um, there's various different um labels that it'll companies will apply to it, but essentially it's the statement that starts with some top line income number, revenue, for example, and gets you down to a net income number, which drives EPS.
8:13
SPEAKER_02: So that's sort of the sort of statement we're talking about.
8:16
SPEAKER_02: That statement may also have something on it called other comprehensive income.
8:20
SPEAKER_02: Um, that's something that usually mostly accountants only care about, um, but it sometimes does show up on the statement, so it's important to look for that number that's net income, and that's really what tends to draw the most most focus.
8:31
SPEAKER_02: Um if you're a public company, meaning you're issuing financial statements that are filed with the SEC, you're required to present three years of your income statement.
8:40
SPEAKER_02: Generally, there's some exceptions to that.
8:42
SPEAKER_02: And then if you're outside of the public realm, um, custom is to present comparative financial statements.
8:47
SPEAKER_02: So two years is is the norm, although there are some situations where maybe you might see a single-year presentation.
8:53
SPEAKER_02: So you need to be consistent in your preparation from year to year if you're presenting multi-year.
8:58
SPEAKER_02: So it's something you sort of live with for a while.
9:00
SPEAKER_02: And given the importance on you know, performance, trends, etc., you want to make sure you're you're being consistent.
9:07
SPEAKER_02: Beyond that, there's not a lot of gap, you know, official FASBE gap that drives the form and content of the income statement.
9:15
SPEAKER_02: There's sort of a general description of what I just kind of laid out as what the statement is intended to represent.
9:21
SPEAKER_02: There's some specific sections in the FASBE codification, but it sort of deals with sort of one-off type things, uh, maybe if you got discontinued operations or um other comprehensive income, which I alluded to, but there's not a lot of sort of the guts of the income statement.
9:38
SPEAKER_02: You know, you have to kind of piece together the different sections of the codification that talk about revenue, that talk about expenses.
9:45
SPEAKER_02: A lot of that derives from the underlying model for the assets and liabilities that drive those expenses.
9:52
SPEAKER_02: So it's you know, it's a little bit of a scavenger hunt, I guess, if you will, to sort of piece together what you what you really need to have in in the income statement.
10:00
SPEAKER_02: Um there is, however, once you get outside of the FASB realm into the SEC's rules, some more prescriptive guidance on the form and content of the financial statements or the income statement.
10:13
SPEAKER_02: I would say that tends to drive most of what you see in practice, particularly for what we would call commercial and industrial companies, so sort of general trading companies.
10:23
SPEAKER_02: Um it's regulation SX, which is the SEC's regulation that covers their financial statement requirements.
10:29
SPEAKER_02: And then for commercial industrial companies, it's Article 5.
10:32
SPEAKER_02: There's some other articles that uh Felix may touch on, given some of his background for companies outside of the call it the products and services space.
10:41
SPEAKER_02: But that really drives then the a little bit more prescription of the captions that should show up on the income statement.
10:49
SPEAKER_02: So moving down, we start with revenue at the top line, and that's really you know, what does the company generate inflows from sort of their major activities?
11:00
SPEAKER_02: Um, pretty obvious to some.
11:02
SPEAKER_02: The SEC requires you to break it out by different categories of revenue, products, services.
11:07
SPEAKER_02: If you happen to be a utility, I know you're big into utilities, that's a required breakout.
11:12
SPEAKER_02: And then other, so anything besides those categories, rental income would be another one you have to break out.
11:18
SPEAKER_02: Then for your cost of sales, which in theory that's sort of your direct cost of generating those revenues, those need to be also presented by those same categories of revenue.
11:30
SPEAKER_02: So if you got multiple lines for revenue, you'd have multiple lines for cost of sales.
11:35
SPEAKER_02: So revenue, cost of sales, those are the big ones.
11:39
SPEAKER_02: There is no requirement to disclose a gross margin.
11:42
SPEAKER_02: Sometimes people think about that as the difference between revenue and cost of sales, but that's not a required caption.
11:47
SPEAKER_02: And so we see mixed practice there.
11:50
SPEAKER_02: Other operating costs and expenses.
11:53
SPEAKER_02: So anything that's not cost of sales, but still an operating cost and expense, but there's not really much detail around what that really means.
12:02
SPEAKER_02: Selling general administrative expenses, that's a specific caption called out in SX 503.
12:08
SPEAKER_02: And then moving down, I would say you see some mixed practice, but the rule does lay out provision for bad debts as a separate line.
12:15
SPEAKER_02: A lot of times that ends up in SGNA.
12:18
SPEAKER_02: Other general expenses, so something other than selling general administrative, um, whatever else might be in there.
12:26
SPEAKER_02: And then you get into non-operating items, so sort of think about your financing income or expense, interest expense, and the like.
12:33
SPEAKER_02: Um, those would be down in sort of the non-operating caption.
12:36
SPEAKER_02: And then you ultimately get down to uh income before tax.
12:40
SPEAKER_02: And that's, I think, for purposes of today's discussion, probably all we really need to uh to deal with.
12:45
SPEAKER_01: Yeah, so no tax, no OCI.
12:47
SPEAKER_01: We won't hit those two topics today.
12:50
SPEAKER_01: And Pat, it's interesting when I was listening to you run through all those captions.
12:55
SPEAKER_01: It does seem like so you have that sort of framework, but then most companies actually just have their practice, right?
13:01
SPEAKER_01: Of where how they've kind of presented things within this framework.
13:06
SPEAKER_01: And do we tend to get many questions about, oh, I want to move from one caption to another?
13:12
SPEAKER_01: Or is it sort of once a company's kind of set out how they're gonna going to approach this absent, maybe like an SEC comment, it's probably unlikely to change.
13:22
SPEAKER_02: I would say we do see the question.
13:24
SPEAKER_02: Some sometimes it comes from how the company's evolving their business.
13:27
SPEAKER_02: Perhaps they've uh sort of repositioned their business in the sector they're operating in.
13:34
SPEAKER_02: Um, sometimes changes in management, they have a different way they'd like to view the business or present it.
13:39
SPEAKER_02: So we do get those questions, and it is a little bit challenging because one, we don't have the specific gap that tells you how it should be presented.
13:47
SPEAKER_02: You alluded to some diversity in practice, which we'll kind of touch on a little bit later.
13:52
SPEAKER_02: So when you decide you want to make a change, there's a question then of how do you deal with that?
13:58
SPEAKER_02: Um if you're just moving things around, sometimes within a subtotal, we might just call that a reclassification.
14:06
SPEAKER_02: There are cases where it's kind of an important enough metric, you're changing a subtotal where we might think about that more through the lens of a change in accounting principle under ASC 250 and really needing to think through preferability.
14:19
SPEAKER_02: Um, in any case, you're, you know, as we alluded to, you need to be comparable.
14:22
SPEAKER_02: So you're gonna have to present all the periods on the same basis.
14:25
SPEAKER_01: Yeah, and I think to that last point, I feel like when I was the audit partner, it was often the thing of, well, this was immaterial, but now it's material, so we want to move it.
14:34
SPEAKER_01: And so definitely even those little items, it makes sense to kind of quote get it right the first time.
14:40
SPEAKER_01: But Felix, bringing you back in, so one of the things uh Pat did allude to my favorite industry, utilities, uh, that there's specific rules, but I I know there are obviously other rules where um for public companies in particular where there's industry-specific guidance.
14:56
SPEAKER_01: So what do you see as you kind of look across that landscape?
15:00
SPEAKER_03: I would say that just like some industries present a classified balance sheet and others don't, the income statement presentations will be different depending on the industry that you're in.
15:08
SPEAKER_03: Article five, like Pat mentioned, applies to the majority of the registrants.
15:12
SPEAKER_03: However, it says if you're one of these entities, then you have to apply a different article.
15:16
SPEAKER_03: And we start first, for example, with bank holding companies.
15:20
SPEAKER_03: The rules for them are tailored to align with the business purpose and operations of the main business, which is lending and deposit generation.
15:29
SPEAKER_03: So it it's presenting instead of from an operating versus non-operating basis, there follow a net interest income approach.
15:35
SPEAKER_03: So as uh as a bank, you start with uh main income generating activity, which is interest income.
15:40
SPEAKER_03: So you start with interest income from loans, investments, and reflected subtotal usually is presented there.
15:46
SPEAKER_03: Then you deduct interest expense from deposits, debt, and other borrowings that the bank may have.
15:51
SPEAKER_03: And then you reflect a net interest income line item, which is usually followed by a provision for credit losses or provision for loan losses.
15:59
SPEAKER_03: Uh also worth noting is that even though this article applies to bank holding companies, this presentation can be applied, or the SEC has a tap topic that says, hey, if you have material activities related to loans and deposits, you may want to consider applying some of the guidance in this article to you.
16:15
SPEAKER_03: The other two that I'll do a quick hit uh that have different uh presentation and income statement is insurance companies.
16:22
SPEAKER_03: As you can imagine, for them, the line items are geared towards the premium, which is the main income that they generate.
16:29
SPEAKER_03: Usually that amount is reflected net of the insurance, which is the amount that you see to a third party, you know, keeping that in the company.
16:36
SPEAKER_03: And also you reflect the claims, losses, and other benefits that are provided to policyholders.
16:41
SPEAKER_03: And finally, registered investment companies and business development companies or BDCs, they follow what it's called Article 6, which evolves more of an investment company type of presentation where you start with investment income first and you trickle down until you get to unrealized gains and losses in that in that entity.
16:59
SPEAKER_01: Wow.
17:00
SPEAKER_01: This listening, uh, Pat, I'm looking at you, seems so I'll use for backwards to us coming from a non-financial services background, but I'm sure the vice versa is true.
17:10
SPEAKER_01: But maybe that is a good lead in then we'll going back to uh the non-financial services revenue, which would be the top line for companies under we'll use the word Article V or most private companies as well, unless they're uh financial institutions.
17:27
SPEAKER_01: And I think one of the areas we get a lot of questions is is something revenue or is it other income?
17:33
SPEAKER_01: And so uh before we get into that though, you know, big picture, how do we think about that, Pat?
17:40
SPEAKER_02: So historically, revenue has really been the gross inflows a company receives as a result of their primary value creating activities.
17:53
SPEAKER_02: You know, the term used to be and still is in at least ASC 606, um, your ongoing major central operations.
18:01
SPEAKER_02: And that was anchored actually in the FASB's conceptual framework.
18:05
SPEAKER_02: They've recently revised their definition of revenue.
18:08
SPEAKER_02: So, in theory, from a pure conceptual standpoint, revenue could be any inflow, which again puts pressure on this, like whether is it revenue or is it other income?
18:16
SPEAKER_02: But certainly from a practice perspective and from the financial statement perspective, we would say revenue still reflects that inflow from your ongoing major central operation.
18:27
SPEAKER_02: If I'm a company that makes a product, it's the gross selling price of those products.
18:32
SPEAKER_02: If I'm providing a service, it's the gross selling price, which is a little unique because a lot of other gains and losses, we're sort of measuring the difference between what we got and what it cost us to generate it, right?
18:44
SPEAKER_02: So we report it net.
18:45
SPEAKER_02: But you know, gross revenue is a really important metric.
18:48
SPEAKER_02: People focus a lot on that.
18:50
SPEAKER_02: And so it's important to make that distinction when you're talking revenue versus other income.
18:55
SPEAKER_02: You could have other inflows from other activities.
18:59
SPEAKER_02: There is then a question of, well, should I present those gross or should I present them net of the related expenses?
19:05
SPEAKER_02: And again, there's probably specific places.
19:07
SPEAKER_02: If you're talking about the sale of a fixed asset or something, it'd be pretty obvious you'd present that net.
19:12
SPEAKER_02: But there may be some other cases where you just have an other inflow stream that's reported as other income.
19:18
SPEAKER_02: So, like for a commercial company, like interest income might be one of those things that would be other income, not part of your ongoing major central operations.
19:28
SPEAKER_01: So, Pat, it's interesting because I do think this distinction between revenue versus other income is something companies run into.
19:36
SPEAKER_01: And maybe to your point, if I'm selling a piece of property or something like that, fairly certain for most companies, that wouldn't be revenue.
19:44
SPEAKER_01: But what types of things do you see companies doing to sort of distinguish between the two?
19:50
SPEAKER_02: I think clearly there's a judgment there, but I think in most cases it tends to be fairly obvious is maybe too strong of a word, but sort of clear based on the nature of the company's business, what is really their major activities, the way they approach the market, the way they generate customer leads, the way they generate sales, you know, those are the types of things we'd be thinking about as revenue, other things that maybe they happen somewhat routinely, but they're still incidental to the business.
20:17
SPEAKER_02: Like, for example, there's many equipment leasing companies where a routine part of their business is to dispose of the equipment they've leased.
20:24
SPEAKER_02: Generally speaking, they will report the sales or the gains or losses on the sales of that equipment as a net other income line, not as a revenue line item.
20:34
SPEAKER_02: Their revenue would be their rental income from the rental business.
20:38
SPEAKER_01: And then this is where I guess if you're changing your business activities, then maybe that's where you could see back to the question on reclassifications and questions.
20:46
SPEAKER_01: So then, Felix, going back to you, I know that there is some guidance then in Article 5 about what you need to break out in terms of captions of revenue.
20:54
SPEAKER_01: And I think Pat alluded to this as well.
20:57
SPEAKER_01: So what do we see in terms of those requirements?
21:01
SPEAKER_03: Under Article 5, what we see is that it requires separate presentation of the income statements, different revenue lines.
21:08
SPEAKER_03: So sales of products is one, sales of services, you have income from rentals, and you may be familiar with this one, which is income from operating utilities separately.
21:17
SPEAKER_03: You only are required to break them out if it exceeds 10% of the total.
21:20
SPEAKER_03: So if the amounts are less than that, you can't combine in a single line item.
21:25
SPEAKER_03: What happens is also that the costs and expenses related to those revenue categories, they also would need to be shown separately in the income statement as well.
21:33
SPEAKER_02: Yeah, and I was just going to add, I think that disaggregation on the face of the income statement, very specific to the SEC Article V rules, it's not the same disaggregation that's required under GAP for the revenues that you have to disaggregate in the footnotes.
21:49
SPEAKER_02: So it's a little bit confusing, right?
21:51
SPEAKER_02: You've got ultimately kind of one gross revenue number, but you might have to cut it a few different ways to comply with both the face of the income statement rules under the SEC.
22:00
SPEAKER_02: DC's guidance and the FASBE's rules for disaggregated income statement expenses.
22:04
SPEAKER_01: Trevor Burrus Yeah.
22:05
SPEAKER_01: So you actually anticipated my question because I was going to ask about that interaction.
22:08
SPEAKER_01: But then just to remind us, the 606 requirements can be on the face or in the footnotes.
22:15
SPEAKER_02: I would say generally speaking, we'd expect those to be in the notes because the principle under 606 is that you disaggregate the various revenue flows in the manner that depicts the nature, amount, timing, and uncertainty of revenue and cash flows as they're affected by economic factors.
22:34
SPEAKER_02: So that's a bit of a mouthful, but it really does get to a much more judgmental, much more business model specific disaggregation.
22:43
SPEAKER_02: So it'd be unlikely that just that sort of standard Article V disaggregation is going to cut it.
22:49
SPEAKER_02: And your financial statements would likely get pretty cluttered, too, if you did that.
22:52
SPEAKER_02: Now maybe for a fairly straightforward that might work, but most of the time you're going to see that in the footnotes.
22:58
SPEAKER_01: All right.
22:58
SPEAKER_01: So look to Article V for the face and then look to 606 for the footnotes.
23:03
SPEAKER_01: But so on that point then, when you were walking through this earlier, Pat, we talked about sort of aligning cost of sales and margins with our revenue.
23:13
SPEAKER_01: So how do you think about that presentation of cost of sales versus operating expenses?
23:19
SPEAKER_01: And again, I think we see differences by industry, but what's the guidance here?
23:22
SPEAKER_01: Trevor Burrus, Jr.
23:22
SPEAKER_02: Yeah, and so maybe one thing just to say at the outset as we start talking about cost of sales versus operating expenses or just like the expense section of the income statement generally, there's uh an overarching concept that we talk about.
23:36
SPEAKER_02: We either present expenses by their function, meaning cost of sales, selling general administrative, research and development, et cetera, versus the nature of the expense.
23:49
SPEAKER_02: So that would be things like materials, labor, equipment depreciation, amortization of intangibles.
23:56
SPEAKER_02: Those would be considered to be the nature of the expenses versus the function.
24:01
SPEAKER_02: For the most part, in practice and kind of what the SEC rules speak to is presenting your income statement by function.
24:08
SPEAKER_02: So all of those expenses, the different types of them, need to be described on the face of the income statement in relation to the function they support in the business.
24:16
SPEAKER_02: So if we start with cost of sales, well, those are the costs and expenses necessary to generate the revenue.
24:23
SPEAKER_02: Very important to sort of measure the efficiency of the operation, right?
24:27
SPEAKER_02: How much does it cost me to generate a sale?
24:30
SPEAKER_02: What are all the expenses that I incur?
24:32
SPEAKER_02: But if you read the SX definition, it just says costs and expenses applicable to sales and revenues, which you could read fairly broadly because you might say, well, if I'm in business to generate revenue, what expenses don't I need to incur to generate that revenue?
24:46
SPEAKER_02: I'd say the counterpoint to that is there's a general understanding that there are some costs and expenses that are necessary just to stay in business or run the business versus those that are really directed at deriving revenue.
24:59
SPEAKER_02: So it's pretty obvious if you're selling a product that the direct costs of the product you're selling would be cost of sales.
25:06
SPEAKER_02: So anything you put into inventory would ultimately be in cost of sales.
25:11
SPEAKER_02: But there could be other expenses that are sort of direct necessary to generate that revenue, but it isn't limited to that.
25:18
SPEAKER_02: I think that is a common misconception is sort of anything that's sort of only direct or only variable with each dollar of revenue is cost of sales.
25:24
SPEAKER_02: That's not necessarily the case.
25:26
SPEAKER_02: You have some other fixed costs, maybe you have a distribution network, a warehousing network that's part of your fulfillment operations, you need all of those costs to get your products to their own customer.
25:39
SPEAKER_02: Those would probably appropriately be classified as cost of sales, even though they may not vary dollar for dollar with each dollar of revenue you're you're generating.
25:48
SPEAKER_01: Aaron Powell But then sort of overhead from say your corporate headquarters, something like that, then would not be included because it's really not related directly to delivering that product.
26:00
SPEAKER_02: Aaron Powell That's right.
26:00
SPEAKER_02: And it gets a little more vague when you know one of the examples.
26:03
SPEAKER_02: So I gave the simple example of a product company, but let's say you're a technology company where you're sort of running an online platform to connect buyers and sellers or service providers and then users.
26:15
SPEAKER_02: Well, clearly a critical part of your mission is that user environment that that both parties are using.
26:22
SPEAKER_02: That's really how you generate your revenue.
26:23
SPEAKER_02: But clearly the operations there don't vary directly with each dollar of revenue.
26:29
SPEAKER_02: That's where we've seen some of the questions coming from the um the SEC for some of these novel business models.
26:36
SPEAKER_02: Companies are trying to describe themselves in a way that gets to sort of a margin metric, but they don't have a business that really lends themselves to that sort of a metric.
26:46
SPEAKER_02: So really understanding how those companies are thinking about the presentation of their income statement is important.
26:53
SPEAKER_02: One other thing you alluded to on kind of the overhead concept, I talked about this nature versus function concept.
27:00
SPEAKER_02: So depreciation and amortization, usually pretty big expense line items for lots of companies.
27:06
SPEAKER_02: They're by definition non-cash in nature in any given period.
27:10
SPEAKER_02: When we talk about EBIT DA, right, the DA is the D and DA, the depreciation and amortization.
27:15
SPEAKER_02: So everybody wants to add those back.
27:17
SPEAKER_02: And a way to make that easy for people is to just show a separate line item on the income statement for depreciation and amortization.
27:24
SPEAKER_02: Well, that's acceptable, but only if you say which line items don't include depreciation and amortization, because in theory, right, you should have depreciation in your cost of sales.
27:35
SPEAKER_02: Chances are you probably have that in your selling general administrative for your office buildings, et cetera.
27:40
SPEAKER_02: You probably have it in RD if you have that for that equipment.
27:43
SPEAKER_02: So it's important to recognize that those really are costs and expenses associated with those functions, but in practice, it is permissible to show those as separate lines as long as you acknowledge that they're in separate lines.
27:56
SPEAKER_01: So then, Pat, to that point, for example, if I was manufacturing widgets and I had my widget factory, I could just put all that depreciation in this other line, but I would need to note that.
28:07
SPEAKER_01: But this was my question.
28:09
SPEAKER_01: Do you need to disclose how much would be, let's say, related to SGNA versus cost of sales, or you just say, oh, those lines exclude it.
28:19
SPEAKER_01: It's all here.
28:19
SPEAKER_02: Trevor Burrus, Jr.: So it's interesting, particularly like if you talk about the uh depreciation that's in your productive facilities.
28:25
SPEAKER_02: I mean, clearly those costs would need to be captured in inventory, you know, under appropriate inventory costing principles.
28:32
SPEAKER_02: So it would be unusual that you would exclude those from cost of sales.
28:37
SPEAKER_02: But if you did, um all you need to do is acknowledge that the cost of sales number excludes the depreciation and amortization shown below.
28:45
SPEAKER_02: Now, if you just show one number, somebody might conclude, well, all of it must belong in cost of sales.
28:51
SPEAKER_02: So that might might or might not be the case.
28:53
SPEAKER_02: So you might want to disclose how much would be attributable to it relative to the other line items, you know, probably a question of your business and how much people care about what's in those other lines.
29:04
SPEAKER_02: But explicitly there's no requirement other than acknowledging that it excludes depreciation and amortization.
29:10
SPEAKER_01: Yeah, and I think your point, I hadn't even thought of the fact that you are including your depreciation in inventory, make it very complicated if you didn't include that in the cost of sales.
29:20
SPEAKER_01: So all right.
29:21
SPEAKER_01: And then you mentioned operating expenses.
29:24
SPEAKER_01: So how are we defining those?
29:26
SPEAKER_02: So there again, really it's kind of everything else that's maybe more core to your operations, but not really cost of sales.
29:33
SPEAKER_02: There isn't a finite or or you know crisp definition for for what those are.
29:39
SPEAKER_02: Um I mentioned like the kind of technology company, so you might see you know technology operations, platform technology as an expense that would probably be considered an operating expense.
29:50
SPEAKER_02: So clearly not really an SGA, but maybe not really cost of sales either.
29:54
SPEAKER_02: So it's a pretty broad category.
29:57
SPEAKER_02: Um I think the important thing is we we hear operations and we think, okay, that's something that's recurring.
30:03
SPEAKER_02: It's part of the operations of the business.
30:05
SPEAKER_02: When we talk a little bit later about operating versus non-operating, the definition of operating in that context is probably a lot broader, meaning it's things that maybe don't happen all the time.
30:16
SPEAKER_02: They're not necessarily routine, but they are nevertheless considered to be operating in character when we're thinking about operating versus non-operating income.
30:25
SPEAKER_01: Okay.
30:26
SPEAKER_01: That's helpful.
30:27
SPEAKER_01: And then Pat mentioned earlier the fact that we're going to be separating our cost of sales into the same categories as revenues.
30:34
SPEAKER_01: So, Felix, is there a specific guidance we're looking at for that?
30:38
SPEAKER_03: Article five does tells you that if you have to break down the revenues in different line items, you will have to then show the cost of sales related to those items as well.
30:48
SPEAKER_03: Other operating expenses, they do just provide like a broad guidance that just says disclose separately if the amounts are material.
30:55
SPEAKER_03: So that provides more judgment uh for registrants determining if there is something else beyond those other items to break out in the income statements.
31:03
SPEAKER_03: And then non-operating expenses, they're allowed to either break out in the face of or in the notes by providing more detail to the extent that there's also materiality there to weigh in.
31:11
SPEAKER_01: All right.
31:12
SPEAKER_01: That's helpful guidance, and I think important to keep in mind, depending on how many different captions of revenue that that you have.
31:19
SPEAKER_01: One thing though that I think you touched on there, and Pat also, I think, touched on this a little, but I know is where we would get a lot of questions again back in my day as an audit partner, would be this question of what is a cost to sale really versus an operating expense.
31:34
SPEAKER_01: And so, you know, Pat, is there any guidance you can point to or good examples that you would give?
31:41
SPEAKER_02: I think there's some that's obvious, right?
31:44
SPEAKER_02: The products, if I'm you know, selling a product and the cost of the inventory, that's pretty obvious.
31:49
SPEAKER_02: If I'm providing a service, then clearly the direct cost of the people involved in providing the service.
31:55
SPEAKER_02: If I'm leveraging some technology in the delivery of either one of those, I think it'd be pretty clear to me that the cost of that technology, whether it's a license fee that I have to pay to someone, a royalty or amortization of some intellectual property, perhaps, that's critical or integral to the product or service I'm delivering, would be important.
32:16
SPEAKER_02: Beyond that, I think again, it's this continuum of, well, why aren't you incurring that cost to generate revenue?
32:24
SPEAKER_02: How is it really more just the sort of baseline operations of your company versus really directed at uh revenue generation?
32:32
SPEAKER_02: And you know, again, I think in practice people tend more toward the more narrow definition of cost of sales, but I think some of the questions we see from the SEC staff when they review filings has a bit more of the orientation toward a well, a broader definition.
32:48
SPEAKER_01: All right.
32:48
SPEAKER_01: Well, and obviously disclosure is going to be important here too, no matter kind of which direction you're going in.
32:55
SPEAKER_01: But Felix, one thing that again that came up that we touched on is this idea of an operating margin or an operating measure, you know, any types of subtotals on the face of the income statement.
33:07
SPEAKER_01: So is there again, what guidance would we look to if a company is contemplating including some of that type of information?
33:14
SPEAKER_03: Well, the interesting thing is that there's no requirement to break out subtotals for operating income under Rule 503 or or under US GAAP for that matter.
33:24
SPEAKER_03: Uh, we don't see that outside of Article 5.
33:26
SPEAKER_03: So, for example, some of the financial services companies that I work with, they don't break out an operating margin.
33:31
SPEAKER_03: However, if a company does voluntarily do that, then there's a distinction to make sure between operating and non-operating that they'll have to then make sure that they the relationship activity aligns with the entity's major ongoing operations because that's going to be critical because otherwise you may end up with an error if you're presenting something outside of uh operating activities of the company.
33:51
SPEAKER_03: Also, it's based on the company's past policy and practice.
33:53
SPEAKER_03: So you may already have, like Pat mentioned earlier, that if you've had experience of presenting something as operating, you would continue to presenting.
33:59
SPEAKER_03: And generally we would expect that uh these expenses are classified as operating.
34:03
SPEAKER_03: You would disclose it separately if they're material as well.
34:05
SPEAKER_03: So that amounts would be considered for that.
34:07
SPEAKER_03: Uh just because I pat said as well, if it's something that is non-recurring, it doesn't mean that it won't be operating.
34:15
SPEAKER_03: So you could have expenses that happen infrequently that will be classified as operating.
34:19
SPEAKER_03: One example is a restructuring activity or disposal of an asset that is used in operations that would be still be considered operating expensive if it's a part of the operating subtotal.
34:28
SPEAKER_01: So it's interesting, Felix.
34:30
SPEAKER_01: You you mentioned, and this came up earlier as well, this idea of past practice or policy.
34:35
SPEAKER_01: And that's not to say a company can never change because if their business is evolving, it's just I think Pat, you made this point.
34:43
SPEAKER_01: Then you have to look at it, has it changed?
34:45
SPEAKER_01: And then you would have to think of it as like a change in accounting policy or and definitely with disclosure.
34:50
SPEAKER_01: All right, that's helpful.
34:51
SPEAKER_01: So then I know a lot of this can be very judgmental and you know, again, different interpretations and outcomes.
34:58
SPEAKER_01: But one of the things I thought that would be helpful is kind of digging into the presentation on some specific types of expenses.
35:07
SPEAKER_01: And I know we talked generally about cost of sales and operating expenses, but I think digging in a little would be helpful.
35:13
SPEAKER_01: And uh one of the places I think that would be a good place to start where I know we get questions is around research and development.
35:20
SPEAKER_01: And then in particular, if a couple companies are collaborating, and so it's, you know, there's there's more than one party involved.
35:28
SPEAKER_01: So, Pat, how do we think about an arrangement like that?
35:30
SPEAKER_02: Yeah, so it's kind of hard enough when you're just dealing with your own company without a lot of guidance to work with.
35:36
SPEAKER_02: Now you introduce a collaborative partner and thinking about how you might cost share, how you might revenue share, how should those types of items be presented on the income statement.
35:48
SPEAKER_02: Tends to be a little bit more limited to certain industries.
35:51
SPEAKER_02: I say you see it a lot in the pharmaceutical biotechnology space, maybe also in sort of core technology software development, probably a lot more so in the pharmabiotech.
36:02
SPEAKER_02: And you really have to get in and understand the nature of those arrangements.
36:07
SPEAKER_02: Um, there is some guidance uh that the FASBE's issued, it's in topic 808 of the codification.
36:13
SPEAKER_02: It deals with collaborative arrangements, but generally what that guidance tells you to do is really just to break down the arrangement into its component parts.
36:22
SPEAKER_02: If you have a revenue arrangement, obviously then that's going to drive revenue.
36:26
SPEAKER_02: If you have something that's fundamentally just RD expenses, then you would just account for those as your research and development activities.
36:34
SPEAKER_02: But where there is clearly a sharing of the risk and rewards, sort of a joint interest, there is a model where you you would essentially just recognize your share.
36:44
SPEAKER_02: So if you're the one maybe performing the RD but getting some compensation, maybe not it's you're not performing services solely on behalf, you're just the one who's incurring the cost, but someone else is sharing those, you might then present those reimbursements as a reduction of the RD expenses rather than presenting them as gross revenues for performing services.
37:07
SPEAKER_02: So it's an area that, again, tends to be somewhat um limited to that industry, but it really just boils down to getting in, understanding what's happening in the arrangement, and then applying the gap.
37:18
SPEAKER_02: Unlike most cases where we would focus on gross revenues and gross expenses, there are some cases where it's appropriate to net those two.
37:25
SPEAKER_01: All right.
37:25
SPEAKER_01: So definitely sounds like important to understand the specifics of the arrangement that you're talking about.
37:30
SPEAKER_01: So that's very helpful.
37:32
SPEAKER_01: And then, Felix, I want to go back to something you said because you made the point that just because something may be non-recurring doesn't mean that's part of operating expense.
37:42
SPEAKER_01: And I feel like where this question often comes up is on impairment of long-lived assets, because you know, a company will try to say, Oh, I haven't had this before or I'm not going to have this again.
37:52
SPEAKER_01: But obviously, that does not mean it's not part of your uh sort of above the line or operating expense.
37:58
SPEAKER_01: So, how do you think about um impairments?
38:01
SPEAKER_03: So if material impairment may be presented on separately on the face of the income statement.
38:06
SPEAKER_03: GAP actually stays that for goodwill impairments, if it's material, you would be presenting it separately on the face of the income statement.
38:14
SPEAKER_03: When it's not presented as part of operating activities, is when it that goodwill impairment relates to discontinued operations.
38:20
SPEAKER_03: However, that threshold for discontinued operations may be a little bit higher.
38:24
SPEAKER_03: I believe there's a there was a web a podcast on discontinued operations that goes into a lot more detail around that, so I won't cover that here.
38:30
SPEAKER_03: But technically that that is the main principle, I guess, on how to determine if you have to present it.
38:35
SPEAKER_03: And we saw it this year in the past reporting cycle when a lot of financial institutions had impairments of goodwill in their reporting units.
38:42
SPEAKER_03: They were breaking it out on the face of the income statement to reflect that material amount of goodwill impairments.
38:48
SPEAKER_01: So then, Felix, I think one of the questions that we hear is you know how you present that within operating income.
38:54
SPEAKER_01: You mentioned presenting it separately, but what does the guidance say about where that would go?
39:01
SPEAKER_03: In in terms of the impairment of long-lived assets, uh different from goodwill, it may be included within operating income based on the function of the associated asset or presented separately in the income statement as its own separate line item.
39:12
SPEAKER_03: So it may be either within SGNA, if it's an asset that relates to that sort of activity, or separately uh in that PL.
39:20
SPEAKER_03: There's another topic that also provides more guidance.
39:23
SPEAKER_03: Uh, it's not really an impairment, but it's also a charge.
39:25
SPEAKER_03: It's a SAP topic 5P that talks about restructuring charges.
39:29
SPEAKER_03: And it does require you to include that charges, even though folks may think about that, it may not be, but it requires folks to present it as part of the income from continued operations and to disclose separately this material as well.
39:41
SPEAKER_03: While financial statements of financial institutions don't have operating versus non-operating, the same framework you usually apply in terms of assessing if you need to present that separately.
39:51
SPEAKER_03: So we do see in practice, even though there's not a required line item in the articles that require it, if the amount is material enough, given that GAAP does require you to present separately on the face the goodwill impairment.
40:00
SPEAKER_03: We see folks also the long-lived asset impairment is material, they also disclose it separately on the face of the financial statement.
40:06
SPEAKER_01: Well, and I feel like this is one area that a lot of companies would like to disclose it separately anyway.
40:11
SPEAKER_01: So it's often, I don't think, a big dispute in terms of where to put it.
40:16
SPEAKER_01: But to that point, we're sort of focused there on operating expense captions.
40:21
SPEAKER_01: So if is there anything you'd highlight specific to non-operating income and expense?
40:27
SPEAKER_03: So for non-operating and expenses and income, the guidance still is Article 5.
40:31
SPEAKER_03: So you would still start with that, look at that guidance.
40:34
SPEAKER_03: Generally, for the majority of companies, the guidance is if it's material, disclose it separately.
40:39
SPEAKER_03: For for financial institutions, what we do see is that there's more prescription.
40:43
SPEAKER_03: I would say that banks have a very detailed list of what they need to disclose for that that sort of uh other income online items.
40:50
SPEAKER_03: Uh what companies need to do is pay attention to the gross amounts when assessing.
40:54
SPEAKER_03: If they do, for example, sometimes they may want to net things that are clearly material, but netting within online items so that they don't clutter the income statement, they'll need to keep track of the gross amounts because if if the gross amounts of those amounts that are being netted are significant, you would likely need to disclose separately between an operating income and uh non-operating expenses.
41:13
SPEAKER_01: Aaron Powell And then how about, and maybe Pat back to you, how about if there isn't something that fits into one of these categories?
41:20
SPEAKER_01: Or I think sometimes, and we alluded to this earlier, these items that are immaterial, how do you think about those?
41:26
SPEAKER_02: Well, I mean, there's obviously the materiality overlay to anything in the financial statements.
41:31
SPEAKER_02: Um, as we've been talking about throughout this podcast, there is not a lot of explicit gap.
41:37
SPEAKER_02: I mean, the guidance I usually try to give to companies and teams is you're putting a line on the face of the financial statements.
41:46
SPEAKER_02: It's an important statement.
41:48
SPEAKER_02: It um drives a lot of comparisons that investors might want to make with other companies.
41:53
SPEAKER_02: So you should be thoughtful about the description, the nature of the cost that's in there.
41:58
SPEAKER_02: And disaggregation is always permitted.
42:02
SPEAKER_02: I mean, Felix alluded to maybe not wanting to clutter your income statement.
42:05
SPEAKER_02: I think that's fair.
42:06
SPEAKER_02: You don't want to have you know a bunch of individual, customized, tailored lines that aren't really meaningful to anyone else.
42:12
SPEAKER_02: But at the same time, the more transparent you can be about something that maybe is a bit of a different type of an expense, probably the better off uh you're gonna be.
42:22
SPEAKER_01: And then, Felix, anything specific from an SEC perspective there?
42:26
SPEAKER_03: In in the SEC guidance, although Article 5 is more general in whether you need to break it down, I would say that Article 9 gives you a right line for breaking out other income.
42:36
SPEAKER_03: That one is about 1% of the aggregate total interest income and other income.
42:41
SPEAKER_03: So you think about it's not net of interest expense, so it's a bigger amount, but it's still 1%.
42:45
SPEAKER_03: So that's something that companies need to track.
42:47
SPEAKER_03: The other thing is for insurance companies that the threshold is different.
42:51
SPEAKER_03: It's 5% of total revenues with includes your premiums and other income as well.
42:55
SPEAKER_03: The key takeaway is that it's uh important to pay close attention to which article you're reporting under so that you determine if you need to break something else differently in the income statement.
43:05
SPEAKER_01: All right.
43:05
SPEAKER_01: Well, we had this topic as one of our podcast topics because we know a lot of people are looking for information on this.
43:12
SPEAKER_01: So hopefully we've provided some illumination with your comments.
43:16
SPEAKER_01: But at the very beginning, I did promise that we'd give an update on the FASBE's ongoing standard setting related to disaggregation of income statement expenses.
43:25
SPEAKER_01: And we did have a podcast in the fall that talked about the proposal and you know where that stood.
43:32
SPEAKER_01: But anything, um Pat, that you can give from sort of an update perspective or that prepare us should be focused on?
43:38
SPEAKER_02: Yeah, well, I think the impetus really for that FASBE project is a lot of the things we've been talking about, right?
43:43
SPEAKER_02: I mean, investors clearly are interested in the underlying nature of the expenses that companies are incurring.
43:50
SPEAKER_02: They're interested perhaps in greater comparability across companies.
43:54
SPEAKER_02: So this FASBE project, while it specifically is only going to require additional disclosure in the footnotes, it's not going to require any change to the face of the income statement.
44:04
SPEAKER_02: It is really driven at this concept of further disaggregation of some of these broad expense categories.
44:11
SPEAKER_02: So as you mentioned, we had a exposure draft last year.
44:16
SPEAKER_02: Comments have been received, the FASBI's done some additional discussions of that.
44:21
SPEAKER_02: We do expect that they will issue a final standard sometime later in 2024, likely not uh effective for at least probably a year, probably 2026, I would guess, for calendar companies.
44:33
SPEAKER_02: But that will require disaggregation of the call it the functional expenses that are on the face of the income statement by their nature in the footnotes.
44:43
SPEAKER_02: That's the high-level summary.
44:45
SPEAKER_01: All right, that's definitely a helpful update, Pat, and it sounds like more to come.
44:49
SPEAKER_01: So we've kind of covered the gamut of what's available from a FASB perspective and then what's available from an SCC perspective.
44:56
SPEAKER_01: And I guess I'm curious from both of you, as you're getting these types of questions, sort of what's a philosophy or sort of the number one you think about as you're talking to um engagement teams and clients in terms of how to think through some of these issues.
45:10
SPEAKER_01: Any sort of one thing in mind, Felix, starting with you?
45:13
SPEAKER_03: I would say that anything that can make the financial statements more useful to a reader, that's something that I would recommend you think about when you prepare your income statement.
45:19
SPEAKER_01: All right, that's gonna be hard to top, Pat.
45:21
SPEAKER_02: But I don't know what's I think we touched on it a little bit, but the whole intersection of non-gap and gap, I think, is is really critical.
45:29
SPEAKER_02: Obviously, non-gap uh measures, non-gap information is really important to users, but you obviously have to anchor that back to the gap financial statement.
45:37
SPEAKER_02: So make sure you're thinking about both of those things together.
45:41
SPEAKER_02: And rightly or wrongly, sort of gap takes primacy, if you will.
45:45
SPEAKER_02: You've got to get the gap presentation right, um, notwithstanding you know what you believe the appropriate non-gap communication would be.
45:52
SPEAKER_01: All right.
45:52
SPEAKER_01: Well, definitely great advice there.
45:54
SPEAKER_01: Maybe I should have started with that question so people could have kept that in mind.
45:58
SPEAKER_01: But very helpful and thank you for all your insight today.
46:01
SPEAKER_02: Thanks, Heather.
46:01
SPEAKER_02: Thanks, Heather.
46:03
SPEAKER_01: That's our show for today.
46:05
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46:25
SPEAKER_01: From Thought Leadership at PWC, I'm Heather Horn.
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