A First Look at the Disaggregation of Income Statement Expenses

Expanding Disclosure

The SEC primarily establishes the categories of expenses that must appear on the face of the income statement [see Regulation S-X Rule 5-03, Statements of Comprehensive Income (17 CFR 210.5-03) for details]. While certain line items such as selling, general, and administrative (SG&A) expenses are required, the SEC permits preparers to determine which costs fall within each category. Moreover, many types of expenses—such as employee compensation or insurance—may be included in multiple line items on the income statement. In discussions with FASB, capital providers (debt and equity) expressed that more transparency regarding the underlying nature of reported expense categories would allow them to better understand a company’s cost structure and potential operational efficiencies, and thereby better predict future cash flows and risks. Insights into what each company includes within an income statement expense line item will allow capital providers to perform more informative time series and cross-sectional analyses.

The standard creates a new subtopic—Subtopic 220-40—in FASB’s Accounting Standards Codification (ASC). Subtopic 220-40 does not affect the face of the income statement. Instead, it requires additional note disclosure to disaggregate certain line items on the face of the income statement, if a line contains one of five natural expense categories. “Natural expense” is a way to categorize expenses based upon the type of benefit provided or consumed in generating such expense. An expense item on the face of the income statement in continuing operations is considered a “relevant expense,” meaning it will require disaggregation in the notes, if the line contains any of the following natural expenses:

• Purchases of inventory (only amounts within the scope of ASC Topic 330),
• Employee compensation,
• Depreciation,
• Amortization of intangible assets, or
• Depreciation, depletion, and amortization (DD&A) related to oil- and gas-producing activities.

If a relevant expense caption consists entirely of just one of the above natural expenses, no further disaggregation of that caption is necessary. One of these natural expenses may be contained within several line-item expenses listed on the face of the income statement, requiring each line-item expense to be disaggregated within the note disclosure. ASU 2024-03 also requires preparers to separately disclose the amount of selling expenses and the entity’s definition of selling expenses. This requirement is expected to provide users with better information about the types of costs that are more likely to vary with changes in revenue. To prevent the financial statements from being misleading, companies may want to include additional qualitative, contextual information regarding the information within the tables.

Implementing this standard will require an analysis of each expense line item presented on the income statement to determine whether it contains one or more of the five natural expenses. If an income statement expense line includes one of the five natural expenses, it is considered a relevant expense caption that must be included in the expense disaggregation disclosure note. For example, if employee compensation is included in a line-item expense, such as SG&A expenses, that line-item expense would be disaggregated in the note disclosure. Exhibit 1 provides a list of expenses often listed on an income statement that most likely do (or do not) contain one of the five natural expenses, thereby requiring the line item to be disaggregated and disclosed.

The standard lists additional types of expenses, gains, or losses that—in order to be consistent with existing disclosure requirements—must be separately listed (in addition to the natural expenses) if contained within a relevant expense caption. These items are listed in Exhibit 2. Any residual amounts—or amounts necessary to reconcile the disaggregated information to the respective income statement line item—must be qualitatively described within the note.

Implementing this standard will require coordination across multiple divisions and will likely require new reports from IT. Preparers should not underestimate the time and effort required to accumulate and report the necessary information in this format.

Case Study

The following case study illustrates the disclosures required by ASU 2024-03. Exhibit 3 contains a traditional generic income statement for Company ABC for the fiscal years ended 20X7, 20X6, and 20X5. In this example, Company ABC had idle plant facilities during the preceding three years, had operating leases (with the costs included in the totals for both SG&A and R&D expenses), and exited a business activity during fiscal year 20X7. In addition, Company ABC includes amounts related to an environmental obligation and reconciling items related to foreign currency translations in its costs of goods sold. These are examples of expenses listed in Exhibit 2 that must also be disclosed. The following discussion focuses on the amounts for 20X7.

Pursuant to its evaluation of which expense items listed on the income statement contain the natural expense categories, Company ABC determines that interest and income tax expenses do not need disaggregation in the notes. The remaining income statement line items are relevant, as each includes costs pertaining to at least one of the natural expense categories requiring a disaggregation note.

The cost of products sold expense disaggregation is illustrated in Exhibit 4. Per Company ABC’s income statement, the 20X7 total cost of products sold is $1,000,000, which is disaggregated across the five natural expense categories in Exhibit 4. Because Company ABC includes warranty costs in the costs of products, warranty expense (Exhibit 2) should also be listed in the disaggregation of the cost of products sold. Since Company ABC has amounts related to an environmental obligation and reconciling items related to foreign currency translations in its costs of goods sold, these expenses must also be reported in the disaggregation.

Note that expense amounts related to inventory, such as cost of products sold, should be disclosed using one of two acceptable methods: the cost-incurred basis or the expense-incurred basis. The cost-incurred basis requires disaggregation of the costs capitalized to inventory during the period (disaggregated by natural expense category), and any inventory costs incurred that were directly expensed to the income statement. Then, to reconcile that sum to the amount of expense recognized on the income statement, the change in inventory balances from the beginning to end of the reporting period, and any other adjustments or reconciling items (along with a qualitative description thereof), such as inventory derecognized during the period or amounts attributable to foreign currency translations, must also be included. The cost of products disaggregation in Exhibit 4 illustrates the cost-incurred basis.

The expense-incurred basis depicts the expenses related to the derecognition of inventory previously capitalized (i.e., cost of goods sold) and any costs incurred that were directly expensed to the income statement during the period. Expenses related to the derecognition of previously capitalized inventory should be disaggregated across the natural expense categories (e.g., purchases of inventory, employee compensation, manufacturing-related depreciation). Had Company ABC used the expense-incurred basis, there would be no need to include the changes in inventory caption, nor the other adjustments and reconciling items caption.

Exhibit 5 presents the remainder of Company ABC’s expense disaggregation footnote disclosure. Company ABC determines that the cost of services contains at least one natural expense—in this case, employee compensation and depreciation—thus requiring disaggregation. The disaggregation of cost of services is presented in Panel A. The total cost of disaggregated services, or $400,000 for 20X7, corresponds to the amount reported on the face of the income statement.

The disaggregation of selling, general, and administrative expenses (SG&A) is presented in Panel B. Costs associated with exiting a business activity must be listed in the disaggregation (see Exhibit 2, Panel A). In this example, the one-time employee termination benefits are an example of costs related to exiting a business activity. Note that because Company ABC recognizes operating lease expenses in more than one expense caption (i.e., cost of services, SG&A, and research and development expenses), the operating lease costs do not have to be separately listed in this disaggregation disclosure (see Exhibit 2, Panel B). Those amounts can instead be included in the “other” category; however, qualitative disclosure defining what is included in the “other” category must be included.

The final disaggregation, R&D expense, is presented in Panel C of Exhibit 5. The R&D expense on the face of the income statement contains only employee costs and the operating lease. Because the operating lease is contained within two different income statement expense line items, it can be included in the “other” category in this disaggregation.

ASU 2024-03 requires a company to disclose additional information regarding selling expenses. What a company includes in selling expenses, and the amount, must be defined and disclosed for each period. Such a disclosure is illustrated in Panel D of Exhibit 5.

In this example, depreciation and amortization are not listed separately on the income statement, but are included within other line items. If those costs had been listed separately, but in a combined line item (such as “Depreciation and Amortization”), the note disclosures would need to include a disaggregation of depreciation and amortization.

Companies may want to include additional contextual information in the tables to prevent the financial statements from being misleading.

Investors and Auditors

Investors should be aware that, while reporting consistency is one of the goals of this new guidance, companies will have discretion in allocating expenses across divisions. Auditors will want to evaluate year-over-year allocations to ensure that expenses are allocated consistently. Companies may perceive there to be a benefit to changing allocations across years, potentially erasing any insights that might be gained from year-over-year consistency.

Capital providers will benefit from the disaggregation of expenses required by ASU 2024-03. The standard only focuses on information disclosure and presentation. Implementing ASU 2024-03 will require cross-function dialogue across departments to produce the data needed by this new format. Companies will want to consider this when planning how to implement the standard.