WHY ISN’T COMPREHENSIVE INCOME COMPREHENSIBLE?By
In May 2010, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued exposure drafts for proposed changes to the presentation of comprehensive income. This was part of the Boards’ joint efforts to improve comparability, consistency, and transparency in financial reporting and also achieve convergence of guidance on comprehensive income presentation under both U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS).
The FASB issued Proposed Accounting Standards Update (ASU), Comprehensive Income (Topic 220): Statement of Comprehensive Income, and the IASB issued Presentation of Items of Other Comprehensive Income: Proposed Amendments to IAS 1. These documents jointly proposed a single continuous statement of comprehensive income with subtotals provided for net income and for other comprehensive income (OCI). They also proposed eliminating the alternative options of reporting comprehensive income in either stockholders’ equity or in a two-statement presentation.
The focus of the FASB’s May 2010 proposed ASU was on the presentation of OCI rather than its components. (In addition to the requirement of a single continuous statement of net income and OCI, the document addressed tax effects associated with the OCI components and mandated certain reclassification adjustments.) It also required the entity to present these OCI components either net or gross of tax, with one amount shown for the aggregate income tax expense or benefit. These items also must be disclosed either on the face of the Statement of Other Comprehensive Income or in a footnote. And the amount of unrealized gains or losses that are reclassified to earnings during the period are to be presented on the face of the OCI statement.
The FASB subsequently released ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, in June 2011, to be effective for public entities for fiscal years beginning after December 15, 2011. This was followed in December 2011 by ASU 2011-12, Comprehensive Income (Topic 220): Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, which deferred the requirement to present items that are reclassified from accumulated OCI to net income separately with their respective components of net income and OCI. The FASB cited many reasons for the deferral, including complaints of added complexity to financial statements and the time constraint of changing accounting systems for the effective date of ASU 2011-05.
Some of the responses to the initial exposure drafts highlighted issues and problems regarding OCI that still remain unresolved. As the Boards continue to work toward joint standards, it’s important for practitioners to understand the chain of events that brought us to the current situation. Thus this article will (1) discuss the nature of the different formats associated with OCI, including their advantages and disadvantages; (2) summarize the nature of the comment letters from practitioners in response to the May 2010 proposed ASU; and (3) provide an update regarding subsequent promulgations.
OTHER COMPREHENSIVE INCOME
Prior to 1997, OCI and its components weren’t required to be reported anywhere in the financial statements, and many items bypassed the income statement and went directly to owners’ equity. In June 1997, Statement of Financial Accounting Standards (SFAS) No. 130, Reporting Comprehensive Income, established the requirement for reporting and displaying comprehensive income and its components as a required component of a full set of general-purpose financial statements. SFAS 130 (codified as Accounting Standards Codification® Topic 220, Comprehensive Income) defines OCI as consisting of net income and “other comprehensive income,” which refers to revenues, expenses, gains, and losses that, under GAAP, are included in comprehensive income but excluded from net income and are consistent with one of four classifications: foreign currency translation adjustments, available-for-sale marketable securities adjustments, minimum required pension liability adjustments, and adjustments on derivative securities that qualify for cash flow or foreign currency hedge accounting treatment.
SFAS 130 specified three options for reporting comprehensive income:
- Displaying the components of other comprehensive income below the net income total in an income statement reporting results of operations (the one-statement approach).
- Including a separate statement of comprehensive income that begins with net income, reports each component of other comprehensive income, and ends with total comprehensive income (the two-statement approach).
- Displaying comprehensive income as part of the statement of changes in equity.
While all three options were acceptable, the FASB encouraged reporting OCI using the first or second option and discouraged using the statement of changes in equity method of display because, as noted by Randall W. Luecke and David T. Meeting, “it hides comprehensive income in the middle of the financial statement” (“How Companies Report Income,” Journal of Accountancy, May 1998).
Comprehensive income is derived from the concept of the all-inclusive income statement, which refers to all the changes in assets and liabilities other than those that involve transactions with owners. Statement of Financial Accounting Concepts (SFAC) No. 6, Elements of Financial Statements, defines comprehensive income as “the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distribution to owners.” As Loudell Ellis Robinson notes in “The Time Has Come to Report Comprehensive Income,” it satisfies financial statement users’ desire for one figure encompassing all the components of income that lead to changes in the overall financial position of organizations (Accounting Horizons, June 1991).
The concept of comprehensive income is closely related to the income statement concept of “clean” vs. “dirty” surplus. Under the clean surplus approach, all income items must pass through the income statement; they sometimes are referred to as items that are reported above the line (the net income line) or items that pass through the income statement. Thus earned surplus (equivalent to retained earnings) is “clean” of these items.
Under the dirty surplus approach, certain items skip the income statement and are reported directly in the statement of owners’ equity. Accordingly, the notion of a dirty surplus includes items that are reported below the net income line, such as unrealized holding gains and losses on available-for-sale securities, additional minimum pension liability adjustments, currency translations, gains and losses of cash flow hedges, and asset revaluations. Items that used to bypass the income statement were then given the name “Other Comprehensive Income.”
The reporting of comprehensive income has always been controversial due to the lack of a conceptual definition of the difference between “net income” items and “other comprehensive income” items. Despite the lack of a conceptual understanding, recent ASUs, such as those on financial instruments and post-employment benefits—ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10), and ASU 2015-12, Plan Accounting: Defined Benefit Plans (Topic 960), respectively—increase the prominence of fair value as the primary measurement attribute, thus expanding the use of OCI. For example, requiring companies to record changes in fair value for many financial instruments (including most loans and issued debt) through OCI magnifies the difference between net income and total comprehensive income in the financial statements.
THE JOINT PROJECT
The joint OCI project undertaken by the FASB and the IASB addresses the volume and complexity of items reported in OCI. As noted, initially the proposal was to require entities to use the one-statement approach. In their final deliberations, however, the FASB and the IASB retreated from that initial proposition by allowing for a one- or two-statement approach.
ASU 2011-05 eliminates the option of displaying OCI in the statement of changes of equity. Empirical research indicates that displaying OCI in the equity section has been the most popular approach despite the lack of transparency provided by that format. Firms with negative and/or small OCI particularly preferred this approach over the other options.
Academic research sheds some light on why the Boards may have wanted to stick with the one-statement approach. In “Comprehensive Income Reporting and Analysts’ Valuation Judgments,” D. Eric Hirst and Patrick E. Hopkins show that the one-statement approach is the most transparent to investors because the income statement presentation of comprehensive income makes information easier to extract and understand (Journal of Accounting Research, volume 36, 1998). Further, James E. Hunton, Robert Libby, and Cheri L. Mazza found that placing OCI in the single continuous statement reduces the likelihood of earnings management by managers (“Financial Reporting Transparency and Earnings Management,” The Accounting Review, January 2006).
Despite these advantages, the one-statement approach also has its drawbacks and is the least popular format among preparers. Combining net income and OCI in one statement enhances the prominence of OCI but may diminish the importance of net income. It may also confuse investors because net income tends to be buried within comprehensive income and becomes a subtotal in the middle of a continuous statement of comprehensive income. This dilutes the focus on net income as the most important performance measure of a company and draws the attention of the financial statement users away from net income to OCI as the “bottom line” of a business. The close proximity of the components of changes in OCI and earnings per share also may further confuse investors. And placing OCI between net income and earnings per share (calculated based on net income) may be misleading to investors.
The one-statement approach also ignores the different nature of net income and OCI and ranks the components of OCI equal with those of net income. Yet net income and OCI are different constructs and shouldn’t be given the same prominence in the financial statements. Net income summarizes the current financial results of operating a company, but most transactions recorded in OCI reflect changes in fair value and consist of unrealized gains or losses driven by external market factors. And while net income reflects complete (or nearly complete) transactions that produce currently available net earnings and cash flows for use by a company’s management, OCI contains long-term and less recurring items that may or may not affect the future cash flows of an entity.
The two-statement approach leaves the income statement in its current form and adds a new statement of comprehensive income. This format further allows financial statement users and management to focus on and discuss (1) the current performance as summarized in net income and (2) the OCI in order to assess a company’s actual liquidity and future cash flow requirements. The components of other comprehensive income present valuable information about a company’s potential future net income and cash flows from transactions generally to be finalized sometime in the future.
COMMENT LETTER ANALYSIS
The FASB received 72 comment letters in response to the May 2010 proposed ASU exposure draft. The vast majority opposed the requirement to combine net income and comprehensive income in a single, continuous statement.
Out of the six questions included in the exposure draft, only two generated significant discussion. The first was Question 1: “Do you agree that requiring a continuous statement of comprehensive income will improve the comparability, transparency, and understandability of financial statements such as relationships between changes in the statement of financial position, the components of other comprehensive income, and the components of net income in each period? If not, why not, and what changes would you suggest to the amendments in the proposed Update?”
About 60% of the comment letters reacted negatively to the proposal, with a great portion of them stating that it would bring “confusion” to users of financial statements by awarding OCI equal or greater prominence to net income and by OCI being misinterpreted as a performance measure. That would accordingly distract users from focusing on the relevant financial measures.
Many of the letters stated that the following actions should occur before the FASB proceeds with a decision: (1) the IASB and the FASB should conceptually define OCI and decide what items should be included in it, and (2) the Boards should decide whether OCI is a performance measure. For example, a letter from the Illinois CPA Society stated, “It seems to us that, over time, other comprehensive income has developed haphazardly as a holding place for changes in net assets that some believe may cause too much income statement volatility.… Other comprehensive income should not simply be a device to avoid income statement recognition, but rather be a well-defined accounting construct.”
The other question that garnered responses was Question 3: “Do you believe that a requirement to display reclassification adjustments for each component of other comprehensive income in both net income and other comprehensive income would improve the understandability and comparability of financial statements?”
Of the 33 letters that gave a “yes” or “no” response to this question, the split was fairly even: 45% said “yes,” and 55% said “no.” Many of those who disagreed with the concept of a two-statement reclassification schedule believed that the format would be confusing and that the adjustments should be listed in OCI. Others said there should be a choice of reclassifying them in either OCI or the notes. One comment letter from an industry source, Emerson, succinctly stated, “We do not believe displaying reclassification adjustments from other comprehensive income to net income is useful or provides any clarity. This requirement amounts to making preparers ‘show their work’ which may be useful to accountants and auditors, but it is not useful for investors to prove the accounting was done correctly.”
AFTER THE EXPOSURE DRAFTS
As noted earlier, ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, published in June 2011, reaffirmed most of the proposed changes in the exposure drafts, such as eliminating the U.S. GAAP option to present the OCI information in a statement of changes in stockholders’ equity. But it allowed entities the choice to either present a single statement of OCI or to present OCI in conjunction with net income in two separate but consecutive statements (see ASC 220-10-45-1A through 1C). The option of using the one- or two-statement method is consistent with the current reporting practice of comprehensive income under IFRS.
The amendments were effective as of the beginning of a fiscal reporting year that begins after December 15, 2011, for U.S. GAAP for publicly traded firms and for fiscal reporting years that begin on or after January 1, 2012, for IFRS.
In the “Background Information and Basis for Conclusions” section, the FASB cited some of the concerns listed in the comment letters to the exposure draft, including the fact that OCI items generally aren’t a function of the entity’s core business and are both long term in nature and beyond management’s control. Furthermore, since comprehensive income is in close proximity to net income, users might be confused as to whether earnings per share (EPS) are based on net income or comprehensive income. While the FASB agreed with the complaint that a conceptual framework was needed regarding what items of income and expense should be included in OCI, it decided not to delay implementation of the presentation guidance due to the need for improved consistency and transparency in financial reporting.
The other major issue regarding comprehensive income—the presentation of reclassifications of OCI into net income, either in whole or part—was addressed in a proposed ASU issued in August 2012, Comprehensive Income (Topic 220): Presentation of Items Reclassified Out of Accumulated Other Comprehensive Income. Basically, it proposed that those comprehensive income items that are required to be reclassified under U.S. GAAP in their entirety should be included in the respective line items in net income. And those that are partially reclassified should be cross-referenced to other disclosures that offer additional explanations regarding their nature. The FASB stated that these disclosures would improve the presentation requirements without imposing significant costs to financial statement preparers. Subsequently, ASU 2013-02, Comprehensive Income (Topic 220): Presentation of Items Reclassified Out of Accumulated Other Comprehensive Income, was released in February 2013 and upheld those provisions.
A recent development occurred in August 11, 2016, when the FASB released its Proposed Statement of Financial Accounting Concepts, Concepts Statement 8—Conceptual Framework for Financial Reporting; Chapter 7: Presentation. As its title implies, Chapter 7 “addresses concepts related to presenting in a financial statement information about items that have been recognized” (paragraph 3). And the concepts in Chapter 7 “are not premised on any specific formats or subtotals” (paragraph 2). For example, it states that the standard applies equally to a single statement of comprehensive income or separate statements of net income and comprehensive income.
Paragraph 31 of the document notes, “Differences between earnings and comprehensive income of business enterprises exist because past standards have required or permitted several types of items to be excluded from net income and later reclassified into net income. There is no conceptual basis for determining which items qualify for that treatment.” Earlier we stated that many of the comment letters to the May 2010 exposure draft wanted the FASB to conceptually define OCI and decide which items it should include and to decide whether OCI is a performance measure. In this quote from paragraph 31, the Board clearly admits that conceptual guidance is absent in the literature.
Thus on August 4, 2016, the FASB issued an invitation to comment on potential financial accounting and reporting topics that it should consider adding to its agenda. The announcement stated that this is an important opportunity for the Board to establish its agenda over the next several years. In the Board’s survey of the FASB’s advisory groups, stakeholders had already identified “potential issues and possible solutions” for several areas, one of which was reporting performance and cash flows, including income statement, segment reporting, other comprehensive income, and statement of cash flows.
We believe that the time for dealing with the unresolved OCI issues is overdue—particularly in regard to examining OCI’s conceptual nature. The FASB and the IASB have worked together to develop the proposed amendments to reporting OCI, yet substantial differences still exist in the treatment of the types of items to be reported in OCI as well as the requirements for reclassifying (recycling) those items into net income.
Under IFRS, for example, gains on revaluations of property, plant, and equipment are recognized in OCI while gains and losses on remeasurement of investment properties are recognized in profit or loss. Additionally, there is an inconsistency between IFRS and U.S. GAAP with respect to whether amounts initially recognized in OCI are reclassified later to profit or loss. Under U.S. GAAP, such items are eventually reclassified into profit or loss, whereas, under IFRS, different items are reclassified in different ways (e.g., actuarial gains and losses related to employee benefit plans recognized initially in OCI aren’t reclassified into profit or loss).
In order to resolve the differences and achieve convergence between the two standards, it’s essential to develop a conceptual definition of OCI. Without determining the more important conceptual issues, such as whether OCI is a performance measure, and, concomitantly, what items OCI is intended to represent (i.e., whether they fulfill the criteria of income or expense or, rather, represent other nonowner changes in equity), the financial reporting of OCI will remain problematic and controversial. Perhaps the FASB should begin by sponsoring a research study to examine the issue. Financial accounting stakeholders want and need closure on its definition and nature.
IMA’S COMMENT LETTERS
The IMA® Financial Reporting Committee (FRC) has monitored and addressed guidance on other comprehensive income. That effort includes submitting a comment letter in response to the FASB’s and IASB’s May 2010 exposure drafts (see http://bit.ly/2eOPmwX). In its letter, the FRC expressed the opinion that the proposal would not result in an improvement in the quality or transparency of financial reporting. The FRC noted that any shortcoming in the reporting of OCI has been caused “by the lack of any clear articulation of the concept behind other comprehensive income” and that “the Boards at some point should more holistically address the concept of OCI.” The Committee also submitted a letter to the FASB in 2011 regarding ASU 2011-05 (http://bit.ly/2edHMde) in which it addressed the reclassification of items out of Accumulated Other Comprehensive Income.
The FRC is currently reviewing the FASB’s proposed ASU, Derivatives And Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. For qualified transactions, gains and losses for hedging activities are deferred in OCI. The Committee plans to submit a comment letter to the FASB.