NZ IFRS 18: Presenting operating expenses by nature, by function, or both?

• What is meant by SMBA, and how entities will need to approach making this first, critical determination in applying NZ IFRS 18 (click here).
• How the new investing category in profit or loss of an entity with a SMBA differs from entities with that have no SMBA (click here).
• How the new financing category in profit or loss of an entity with a SMBA of providing financing to customers differs from other entities (click here).
• How foreign exchange gains or losses will need to be disaggregated between the three new categories to be presented in an entity’s Statement of Profit or Loss (i.e., operating, investing, financing) (click here).
• Example of how the Statement of Profit or Loss could look like for a typical retail, wholesale, manufacturer, or service business with no SMBA (click here).
• Illustrative examples: Entities that have a SMBA that is asset investment (click here).
• Illustrative examples: Entities that have a SMBA that is providing finance to customers (click here).
• How entities will be required to reassess how they aggregate, disaggregate, and label line items in the financial statements and notes (click here).

In this month’s article, we look at changes to how entities will be able to present their expenses under NZ IFRS 18, compared to the current requirements under NZ IAS 1.

What are the current presentation requirements for expenses (NZ IAS 1)?

Under NZ IAS 1, an entity must choose one of two ways to present its expenses in the statement of comprehensive income, being by ‘nature’ or by ‘function’.
 

	Nature	Function
Description	An allocation of expenses is based on the nature of the economic resources consumed to accomplish the entity’s activities (but without reference to the activities in relation to which the economic resources were consumed).	Allocation of expenses based on the activity within the entity’s operations to which the consumed resources relate.
Examples (line items)	Entities presenting by nature will present (as line items): Inventories expensed. Employee expenses. Depreciation, etc. That is, there is no presentation of Gross profit subtotals, nor any mention (or grouping) of expenses into the activities of the entity.	Entities presenting by function will present (as line items): Gross profit (being the subtotal Revenue, less, Cost of goods sold/Cost of sales).   Other line items that describe the entity’s activities: Distribution costs. Marketing costs. Research and development costs. Occupancy costs. Administrative costs. That is, individual costs such as Employee expenses, Depreciation etc., will be split across these functions.

 

However, in practice, over time many entities started to present their expenses on a ‘hybrid’ basis, typically where ‘Gross profit’ was presented (i.e., by function), and then the expense line items beneath Gross profit were made by nature. This hybrid presentation approach was not explicitly permitted by NZ IAS 1.

Under NZ IFRS 18, this hybrid presentation is now written into and permitted by the standard.

What are the new presentation requirements for expenses (NZ IFRS 18)?

Under NZ IFRS 18, within the operating category, entities must classify and present expenses in different line items so that they provide the most useful structured summary of expenses.

This can be done by nature, by function, or a mix of the two (i.e., hybrid presentation approach), based on the consideration of various factors prescribed by NZ IFRS 18 (refer below).

How to decide whether to present expenses by nature, function, or on a hybrid basis

As noted above, an entity does not have a free accounting policy choice when determining the presentation basis for operating expenses.

Rather, an entity must consider various factors prescribed by NZ IFRS 18, and then determine the most appropriate basis.
 

Factors to consider	Example
What line items provide the most useful information about the main components or drivers of the entity’s profitability?	Use of cost of sales by a retail entity, as it provides relevant information about whether the revenue generated from the sale of goods covers what, for retailers, are mainly direct costs, and by what margin.
What line items most closely represent the way the business is managed and how management reports internally?	An entity with multiple major functions may classify expenses by those functions, whereas an entity with a single function (e.g. a lender) may classify expenses by nature.
What standard industry practice entails?	If certain industries have a common practice in how operating expenses are classified, using the industry accepted approach may make comparison easier between entities.
Whether the allocation of particular expenses by function would be arbitrary to the extent that the line item presented would not provide a faithful representation of the function?	Allocating impairment of a large group of assets (e.g. property, plant and equipment, right-of-use assets, etc.) by function (e.g. research and development, administration, etc.) may be arbitrary, as assets may be used in multiple functions.

 

Consistency from period to period

Once the entity decides on the appropriate presentation for expenses in the operating category as either by nature, by function, or a mixed format, it should stick with this to ensure consistency in presentation from one period to another. It can only change the basis if things change, such as:

• When there is a significant change in the nature of the entity’s operations
• When the entity reviews its financial statements and concludes that another presentation would be more appropriate, considering the criteria in NZ IAS 8 Basis of Preparation of Financial Statements, or
• A requirement in an NZ IFRS requires a change in presentation.

 

Any change in presentation basis (e.g. a change in judgement concerning aggregation of income and expenses) is accounted for as a change in accounting policy; therefore, comparative information must be restated. It should be noted that a change in accounting policy is only permitted if it results in the financial statements providing reliable and more relevant information about the effects of transactions, other events or conditions on the entity’s financial position, financial performance or cash flows. We therefore encourage entities to give considerable thought as to how they classify operating expenses in the first year because a change in the second year would require an analysis and justification of the ‘relevant and reliable’ criteria for changing policies (as noted above).

 

Presenting operating expenses by nature can be gross or net

If entities present operating expenses by nature, the amounts presented in the operating category in the statement of profit or loss need not be the amounts recognised as an expense for the period.

NZ IFRS 18, paragraph B84 notes that they could include amounts that have been recognised as part of the carrying amount of an asset.

In such cases, an additional line item must be disclosed in the statement of profit or loss (operating category) for the change in the carrying amount of the relevant asset.

For example, a manufacturer who earns $300 of revenue may incur the following expenses during the year (amounts prior to a portion being recognised in the carrying amount of assets):

• Wages:                         $100
• Electricity:                    $80
• Depreciation:                $45

A portion of these expenses will be included in the carrying amount of the entity’s unsold finished goods inventories for the period.

An entity could, for example, present in the statement of profit or loss as follows:
 

	$
Revenue	300
Wages	(100)
Electricity	(80)
Depreciation	(45)
	75
Change in the carrying amount of inventories (assumed)	25
Operating profit	100

If, for example, the manufacturer decides to present in the operating category only the amounts recognised as an expense during the period, then the statement of profit or loss may instead be as follows (assuming the change in inventories of $25 comprises: (i) $10 for wages, (ii) $10 for electricity; and, (iii) $5 for depreciation:
 

	$
Revenue	300
Wages	(190)
Electricity	(70)
Depreciation	(40)
Operating profit	100

 

Next month

Next month, we will look at an example of additional disclosures required regarding expenses presented by function.

 

Why do you need to consider NZ IFRS 18 now? Transitioning your financial statement presentation from NZ IAS 1 to NZ IFRS 18 is not a simple exercise. NZ IFRS 18 is not just about reclassifying line items. While this may be the result, how and why an entity gets to those reclassifications is challenging because NZ IFRS 18 is a long and complex standard. Addressing the how and why involves entities making judgements regarding specified main business activities and income and expense categories. These judgements must be documented, supportable and evidenced. In addition, system changes will be required to appropriately tag expenses to the five new categories. Entities should, therefore, start their NZ IFRS 18 implementation projects now in order to be ready to retrospectively restate comparatives from 1 January 2026. Our comprehensive In Practice publication will help you on your NZ IFRS 18 implementation journey. For more details, including our "Six steps to a successful adoption of NZ IFRS 18," please refer to our Adopting NZ IFRS 18 page.

 

Need help

Please contact our Financial Reporting Advisory team for assistance in your entity’s adoption journey of NZ IFRS 18.

For more on the above, please contact your local BDO representative.

This article has been based on an article that originally appeared on BDO Australia, read the original article here.