Hong Kong – HKFRS 18: A Paradigm Shift in Financial Performance Presentation

Overview of New Accounting Standards —HKFRS 18 “Presentation and Disclosure in Financial Statements”

In July 2024, the Hong Kong Institute of Certified Public Accountants (HKICPA) issued Hong Kong Financial Reporting Standard (HKFRS) 18 Presentation and Disclosure in Financial Statements, the equivalent of International Financial Reporting Standard (IFRS) 18 Presentation and Disclosure in Financial Statements issued by the International Accounting Standards Board (IASB). HKFRS 18 replaces Hong Kong Accounting Standard (HKAS) 1 Presentation of Financial Statements. HKFRS 18 introduces new requirements that will affect the way entities across various industries report and disclose financial performance in their financial statements. Provisions from HKAS 1 that have not been amended have been transferred to HKFRS 18 and other HKFRSs for continued application. HKFRS 18 will be effective for annual reporting periods beginning on or after January 1, 2027, but entities may apply it earlier. Entities must retrospectively apply HKFRS 18.

Key New Requirements of HKFRS 18

HKFRS 18 introduces three main sets of new requirements to improve the way entities report financial performance, providing investors with better foundations for analyzing and comparing entities.

1. Income Statement

To improve the structure of the income statement, HKFRS 18 introduces three new classification categories: operating, investing, and financing (these categories have different meanings from those in the cash flow statement). It requires entities to report two newly defined subtotal items: operating profit and profit before financing and income tax.

• Operating Category is the default category, which includes all revenues and expenses not classified into other categories. This means the operating category includes, but is not limited to, revenues and expenses from the entity’s core business activities, regardless of whether they are volatile or recurring.
• Investing Category includes income and expenses generated from assets that are independent of the entity’s core business activities, including cash and cash equivalents, and investments in associates, joint ventures, and unconsolidated subsidiaries.

Income and expenses classified as investing include:

• Share of profit from associates and joint ventures accounted for using the equity method
• Rental income and fair value gains/losses from investment property
• Interest income and fair value changes from debt securities
• Dividends and fair value changes from equity investments
• Financing Category includes income and expenses arising from transactions related to financing, such as bank loans, bonds, and interest expenses on other liabilities like leases and pension obligations.

Entities Engaged in Specific Core Business Activities

HKFRS 18 sets additional classification requirements for entities engaged in specific core business activities, such as those providing financing to customers (e.g., banks) or those whose primary business activity involves investment assets (e.g., insurance companies and real estate companies). These entities must classify their income and expenses as operating, while most other entities will classify them as investing or financing. HKFRS 18 also provides accounting policy options for entities in specific business activities when classifying certain income and expenses.

Classification of Specific Income and Expenses

• Exchange Differences

HKFRS 18 requires entities to classify exchange differences in the same category as the item that generated the difference in the income statement. For example, exchange differences arising from bank loans should be classified as financing. However, if classifying exchange differences in this way incurs excessive cost or effort, entities are allowed to classify the exchange difference under the operating category.

• Other Specific Income and Expenses

HKFRS 18 also requires the classification of fair value gains/losses on derivatives and income and expenses from hybrid contracts. The classification of fair value gains/losses on derivatives depends on whether the derivative is used to manage identified risks and whether it is designated as a hedge. For hybrid contracts that consist of a host debt instrument and an embedded derivative, the classification of income and expenses depends on whether the embedded derivative is separated from the host debt and the nature of the hybrid contract.

Impact on Entities

• The classification of income and expenses will differ depending on the entity’s core business activity. Entities need to carefully assess their core business activity and determine whether they are engaged in specific core business activities.
• Entities will need to analyze their income statement structure and evaluate how to adjust their current reporting methods.
• Entities holding significant amounts of derivatives and foreign currency-denominated items may incur additional costs and effort to classify exchange differences and derivatives in the appropriate categories within the income statement.
• Entities may need to make decisions about their accounting policies, such as the classification of certain income and expenses for entities engaged in specific core business activities.
• Changes in the income statement structure may affect an entity’s current reporting practices, internal processes, and accounting systems.

2. Management-Defined Performance Metrics (MPM)

HKFRS 18 defines MPMs as subtotals of income and expenses excluding those specified or required by other HKFRSs. These are metrics used outside the financial statements for public communication and to convey management’s view of a specific aspect of the entity’s overall financial performance. Examples of MPMs include adjusted profit, adjusted operating profit, adjusted profit before interest, tax, depreciation, and amortization (EBITDA), etc.

HKFRS 18 requires entities to disclose the following information about their MPMs in a separate note:

1. Reconciliation with the most directly comparable subtotal or total specified in HKFRS 18 or other HKFRSs, including disclosure of the tax effects and non-controlling interest effects for each item.
2. A description of how the MPM conveys management’s view and how it is calculated.
3. A description of any changes made to the MPM or how it is calculated.
4. A statement that the MPM reflects management’s view of a specific aspect of the entity’s overall financial performance, which may not necessarily be comparable with similar metrics from other entities.

Impact on Entities

• If entities frequently use non-GAAP measures for public communication, they need to assess whether these metrics meet the MPM definition since they will now need to be reported in the financial statements and subject to audit.
• Entities already using MPMs may incur costs when providing reconciliations and determining the tax and non-controlling interest effects for each adjustment. Entities may need to establish or revise internal processes for preparing reconciliations.
• Entities may need to reassess their external communication strategies based on the latest disclosure requirements for MPMs.

3. Information Classification

HKFRS 18 provides guidance on classifying transactions and other events within each line item in the primary financial statements and in the notes to the financial statements. It requires entities to:

1. Aggregate items with similar characteristics and disaggregate items with different characteristics.
2. Classify items in a way that does not obscure important information or reduce the understandability of the reported information.
3. Use meaningful labels for aggregated items, and only use “other” when a more informative label cannot be found.
4. Include items in both the primary financial statements and notes, ensuring they complement each other.

HKFRS 18 requires entities to report operating expenses by their nature or function. If expenses are classified by function, entities must disclose in the notes the amounts of depreciation, amortization, employee benefits, impairment losses, and inventory write-offs included in the operating categories of the income statement.

Impact on Entities

• Entities will need to review and adjust their internal reporting systems and processes to ensure compliance with the aggregation and disaggregation requirements. They will also need to gather relevant information to meet the additional disclosure requirements for the five categories of specific operating expenses.
• Entities will need to use more informative labels for items marked as “other” in the financial statements, such as for other expenses/income, other receivables/payables, or provide more detailed information for these items.

Other Changes Introduced by HKFRS 18

Hong Kong Accounting Standard No. 7 (HKAS 7) “Statement of Cash Flows” has also been revised with several scope limitations to enhance comparability. The revisions include:

1. Requiring entities to use operating profit as the starting point for indirect reporting of cash flows from operating activities.
2. Removing the accounting policy option for classifying interest and dividend cash flows.

In addition, several requirements from HKAS 1 have been moved to HKFRS 7 “Financial Instruments: Disclosures” and HKAS 8 “Accounting Policies, Changes in Accounting Estimates and Errors.” These include:

1. Disclosure requirements for financial instruments classified as equity.
2. Concepts of true and fair view and compliance with relevant HKFRSs.
3. Going concern.
4. Accrual accounting.
5. Disclosure of choices and applications of accounting policies.

To reflect the revisions in HKAS 8, its name will be changed to “Basis of Preparation of Financial Statements.”

Implementation of HKFRS 18

The implementation of HKFRS 18 will have a wide impact on entities across different industries. To address this change, entities should begin preparing for implementation early. Entities should carefully read the full text of the new standards and assess their impact on operations and reporting. Entities should get in touch with professional Certified Public Accountant for any questions regarding the implementation of HKFRS 18.