comprehensive income: how to apply the rules of fasb's recent exposure draft

Comprehensive Income: How To Apply the Rules of FASB’s Recent Exposure Draft

Cheri L. Reither and Pamela A. Smith

Cheri L Reither, Ph.D., CPA, CMA, is on the research staff at the FASB and is managing the project on reporting comprehensive income. Pamela A. Smith, Ph.D., CPA, is an assistant professor of accounting at Northern Illinois University. The views expressed in this article are those of the authors. Official positions of the FASB are determined only after extensive due process and deliberations.

The authors give an insider’s view of FASB’s recent Exposure Draft on comprehensive income. After describing the EDs provisions, they show the reader how to apply them to the financial data ofa well- known company-to explore how the ED could affect financial results, they also examined the impact on anonymous companies from 25 different industries.

nder current accounting standards, enterprises are required to provide as part of a full set of general purpose financial U statements a statement of financial performance (income

statement), a statement of financial position (balance sheet), and a statement of cash flows. However, a recent FASB Exposure Draft (ED) proposes that these financial statements be expanded toinclude a statement that reports comprehensive income. If adopted as proposed, the ED, Reporting Comprehensive Income, would require enterprises to display comprehensive income items separately that are now reported directly in equity in financial performance statements.

NOT A NEW IDEA Comprehensive income is not a new idea. It was defined in

Concept Statement No. 3, “Elements of Financial Statements of Business Enterprises” (19811, as “the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.” Furthermore, Concepts Statement No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises” (1984), concluded that a full set of financial statements for a period should show “comprehensive income (total nonowner changes in equity) for the period.”

The purpose of reporting comprehensive income is to display all nonowner changes in equity that result from recognized transactions

CCC 1044-8136/96/0704029-10 0 1996 John Wiley & Sons, Inc.

The Journal of Corporate Accounting and FinancdSummer 1996 29


It could be argued that comprehensive income reporting will not result in new information.

and other economic events of the period. In current practice, most nonowner changes in equity are reported in an income statement. However, there are some nonowner changes in equity that are reported directly in equity. Comprehensive income provides a vehicle to capture all nonowner changes in equity that result from recognized transactions or other economic events.

The ED is limited to the display of comprehensive income and its components in a statement of financial performance. It does not address issues of when components of comprehensive income should be recognized in financial statements or how those components should be measured. The ED divides comprehensive income into net income and other comprehensive income. Other comprehensive income is used to refer to all items of comprehensive income that are not included in net income. Under present accounting standards, the most common items of other comprehensive income are foreign currency translation adjustments, minimum pension liability adjustments, and unrealized gains and losses on available-for-sale securities. Those items result from the application ofFAS 52, “Foreign Currency Translation,” FAS 87, “Employers’ Accounting for Pensions,” and FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.”

THE NEED FOR REPORTING COMPREHENSIVE INCOME Information about components of other comprehensive income is

currently available in a statement ofequity or in notes to the financial statements. It could be argued that comprehensive income reporting will not result in new information, but will simply require that information now available be displayed in a different location. But when components of other comprehensive income are displayed in a statement of financial performance, they will become more transparent. That transparency will make the financial information more accessible to financial statement users and will make enterprises easier to compare.

The Association for Investment Management and Research (AIMR), one of the largest and most influential financial statement user groups, recently advocated that type of transparency. In its 1993 report entitled Financial Reporting in the 1990s and Beyond, the AIMR stated that ”much effort is required of analysts to locate and evaluate all of the income statement items that can have a bearing on their forecasts of the future and the valuation of the firm.” The AIMR argued that all of the information regarding an enterprise’s economic activity should be reported in one place so that financial statement users could optimally utilize the information available. The AIMR urged the Board to implement a requirement for reporting comprehensive income. Comprehensive income reporting will not only discontinue the practice of taking certain items directly to equity, but also will provide a framework for addressing future accounting issues.

One such accounting issue that is being addressed by the FASB

30 The Journal of Corporate Accounting and FinancdSummer 1996


The ED does not change the display of or components of present-day net income.

is accounting for financial instruments and the display of associated unrealized gains andlosses. In fact, the need to address comprehensive income reporting became a priority a t the FASB because ofits project on financial instruments, particularly the portion of the project that focuses on derivatives and hedging. Currently, many financial instruments are “off-balance-sheet items.* The Board is considering recognizing more of such financial instruments in the financial statements and measuring them at fair value. The Board realizes that that could have a dramatic effect on financial statements if the unrealized gains and losses associated with fair value changes were reported in the income statement as part of net income. However, the Board concluded that it is appropriate and consistent with the Concepts Statements to exclude some unrealized gains and losses from net income and report them as part of other comprehensive income. In the derivatives and hedging portion of the financial instruments project, the Board has tentatively concluded that some unrealized gains and losses associated with derivative financial instruments will be displayed as part of other comprehensive income in a statement of financial performance.

GENERAL PROVISIONS OF THE ED The ED discusses the display of items of other comprehensive

income in a statement offinancial performance and the display of the accumulated balances of those items in a statement of financial position. The general provisions of the ED are described below.

Display of Comprehensive Income in a Statement of Financial Performance

The ED does not change the display of or components of present- day net income. Rather, the ED allows comprehensive income to be displayed in either a one- or two-statement format. Ifa one-statement format were to be used, net income would be displayed as a subtotal within that statement, with other comprehensive components displayed below that subtotal. If a two-statement format were to be used, the first statement would be a present-day income statement. The second statement would begin with net income-the bottom line of the first statement-and that would be followed by other comprehensive income components. Regardless of the format chosen, enterprises must display a total for comprehensive income and a per- share amount(s) for that total on the face of the statement where comprehensive income is reported. (An enterprise should determine if single or dual presentation of comprehensive income per-share is appropriate based on its capital structure, simple or complex, as defined in AJ?B No. 15, Earnings Per Share.)

The ED states that other comprehensive income should be classified in the statement of financial performance based on the nature of items includedinit. For example, under present accounting standards, other comprehensive income components would be classified into foreign currency items, unrealized gains and losses on

“he Journal of Corporate Accounting and FinancdSummer 1996 31


securities, and minimum pension liability adjustments. However, the ED points out that future accounting standards (i.e., financial instruments) could result in additional classifications or additional items within present classifications.

Display of Other Comprehensive Income in the Equity Section of a Statement of Financial Position

Enterprises are now required to include the accumulated balances of other comprehensive income items in the equity section of a statement of financial position. Although the ED does not change that requirement, it does include specific requirements for the classification of those items in equity. The objective is to make changes in other comprehensive income components traceable and reconcilable to their accumulated balances in equity. Enterprises will not be permitted to “bury” accumulated balances of other comprehensive income in the equity accounts of retained earnings or other paid-in capital.

The ED requires that other comprehensive income items reported in a statement of financial performance be transferred to a separate component in equity so that the changes can be combined with “accumulated other comprehensive income.” Individual classifications within accumulated other comprehensive income can be displayed on the face of the statement offinancial position, displayed in a statement of equity, or be disclosed in the notes to the financial statements. In any case, the display classifications should match the classifications used in the statement of financial performance. For example, under present accounting standards, there could be accumulated balances separately displayed or disclosed for foreign currency translation adjustments, unrealized gains andlosses on securities, and minimum pension liability adjustments.

Illustration of General Provisions To illustrate the general provisions of the ED, they have been

applied to General Electric Corporation’s (GE) financial statements for the years ended December 31,1995 and 1994. Both the one- and two-statement formats for reporting comprehensive income are illustrated. In addition, the equity portion of the statement of financial position is shown.

GE’s financial statements reported two items of other comprehensive income: foreign currency translation adjustments and unrealized gains and losses on investment securities. GE included the balances of those items in the equity section of the balance sheet, and the changes in those balances were shown in a note to the financial statement that detailed the components of share owners’ equity.

Exhibits 1, 2,and 3 provide GE’s recasted financial statements. Exhibits 1 and 2 illustrate the one- and two-statement formats, respectively. Exhibit 3 illustrates the equity section of GE’s balance sheet.

32 The Journal of Corporate Accounting and Finance/Summer 1996

Comprehensive Income: How To Apply the Rules of FAsB's Recent Exposure Draft

Exhibit 1. One-Statement Format

General Electric Company and Consolidated Affiliates Statement of Earnings and Comprehensive Income

For the years ended December 31 (In millions) Revenues Costs and expenses Earnings from continuing operations before

Provision for income taxes Earnings from continuing operations Earnings (loss) from discontinued operations Net earnings Other comprehensive income:

income taxes and accounting change

Unrealized gains(1osses) on investment securities Foreign currency translation adjustment Total other comprehensive income

Comprehensive Income

Earnings per share (in dollars): Continuing operations Discontinued operations Net earning per share Comprehensive income per share

1995 1994 $70,028 $60,109 60.291 51.448

9,737 8,661 (3,164) (2,746) 6,573 5,915 - ( 1,18 9) 6,573 4,726

1,810 (1,658) 127 180

1,937 (1,478) $8,510 $3,248

$3.90 . $3.46 - (.69) u $5.05 $1.90

Pro Forma Application of General Provisions to a Sample of Companies in Various Industries

To gain insight into how the general provisions of the ED could affect the financial results ofvarious industries, they were applied on a proforma basis to summarized financial information ofone company from each of twenty-five selected industries. "he company chosen from each industry was the top-ranked Fortune 1000 company as ranked by the April 26, 1996 issue of Fortune. Unless indicated otherwise, financial data from 1995 were used for each company. Exhibit 4 provides that information.

Although generalizations cannot be based on information from just one company within each of twenty-five industries, it is interesting to note some of the more common items of other comprehensive income and their relative size. For instance, most companies reported foreign currency translation adjustments. However, that item is relatively small when compared to net income and other items of comprehensive income. Many of the companies reported unrealized gains or losses on



Exhibit 2. Two-Statement Format

General Electric Company and Consolidated Affiliates Statement of Earnings

For the vears ended December 31 (in millions) Revenues Costs and expenses Earnings from continuing operations before

income taxes and accounting change Provision for income taxes Earnings from continuing operations Earnings (loss) from discontinued operations Net earnings

Earnings per share (in dollars): Continuing operations Discontinued operations Net earning per share

1995 $70,028 60.291

9,737 53.164) 6,573 -

$6,573

1994 $60,109 51.448

8,661 (2.746) 5,915 (1.189) $4,726

$3.90 $3.46 0

$3.90 $2.77

General Electric Company and Consolidated Affiliates Statement of Comprehensive Income

For the vears ended December 31 (in millions) Net earnings $6,573 $4,726 Other comprehensive income:

- 1995 1994

Unrealized gains(1osses) on investment securities 1,810 (1,658) Foreign currency translation adjustment 127 180 Total other comprehensive income 1.937 (1.478)

Comprehensive income $8,510 $3,248

Comprehensive income per share (in dollars) $5.05 $1.90

securities. The two companies fkom the insurance industries reported unrealized losses on securities that are relatively large compared to their net income. Finally, only two of the companies reported a minimum pension liability adjustment. However, for one of those companies that amount was larger than other components of other comprehensive income and was relatively large when compared to its net income.

RECLASSIFICATION ADJUSTMENTS: ANOTHER PROVISION IN THE ED

In addition to the above general provisions, there is a provision in the ED that requires more extensive explanation. That provision



Exhibit 3. Equity Portion of the Statement of Financial Position

General Electric Company and Consolidated Affiliates Share Owners’ Equity

At December 31 (in millions1 Common stock Accumulated other comprehensive income:

Currency translation adjustments Unrealized gains (losses) on investment securities

Other capital Retained earnings Less common stock held in treasury Total share owners’ equity

- 1995 $594

61 1,000 1,602 34,528 (8.1761 $29,609

1994 $594

66 (810) 1188

30,793 (5.3121 $26,387

relates to the requirement for what the ED refers to as reclassification adjustments. Those adjustments are necessary to avoid double counting items that are displayed as part of net income for the current period that also had been displayed as part of other comprehensive income. This can best be explained by using an example associated with available-for-sale securities.

Under the provisions of Statement 115 (“Accounting for Certain Investments in Debt and Equity Securities”), when an enterprise designates a security as available for sale, it must account for that security at fair value and report the accumulated balance of the changes in that fair value in equity. According to the ED, those changes in fair value would be reported in other comprehensive income as unrealized holding gains when they occur, and the accumulated balance of those changes would continue to be reported in a separate component of equity. When the enterprise sells or otherwise disposes of that available-for-sale security, it must report the total amount of the realized gain (selling price less cost) in net income. However, because the unrealized holding gain was reported in other comprehensive income as it occurred, reporting the total gain in net income when the security is sold results in the gain being included in total comprehensive income twice. Therefore, when the gain is reported in net income, it must be deducted from other comprehensive income to avoid double counting. That deduction is referred to as a reclassification adjustment.

“he Board decided that if it is practicable to ascertain reclassification adjustments, enterprises should be required to display them separately from other changes in the balance of items of other comprehensive income. Practicability equated to the ease with which those adjustments could be calculated. Thus, if an enterprise can

“he Journal of Corporate Accounting and FinancdSummer 1996 35


I I I I I I

~~

Exhibit 4. Pro Forma Application of the ED to One Company from Each of Twenty-Five Selected Industries

' INDUSTRY NET INCOME FOREIGN UNREALIZED MINIMUM CURRENCY GAINS/U)SSES PENSION

LIABILITY

I Computers & Omce Equip. 4,116.0 364.0 57.0 0.0

Diversified Financial 2,144.0 0.0 12.0 0.0

Food & Drug Stores 302.8 0.0 0.0 0.0

Forest & Paper M u c t s 1,153.0 42.0 0.0 0.0 I

COMPREHENSIVE INCOME

~ ~~ - ~~~ ~

1 Insurance: Life & Health (Stock) 554.0 47.0 (1,153.0) 0.0 (552.0)

I i MetalProducts 818.8 (99.9) 0.0 0.0 718.0

1 Metals I 790.5 I (10.4) I 0.0 I (5.3) I 774.8

Commercial Banks I 3,126.0 I 34.0 I (146.0) I 0.0 I 3,014.0

, Pharmaceuticals 2,403.0 183.0 0.0 0.0

Savings 516.0 0.0 72.5 0.0

Scientific & Photographic (472.0) (3.0) 432.0 0.0

Computer & Data Services (1994) I (19.6) I 0.0 I 20.0 I 0.0

Aerospace Beverages

Chemicals

.4

682.0 0.0 0.0 0.0 682.0 80.0 17.0 0.0 0.0 97.0

3,293.0 0.0 0.0 0.0 3,293.0

Electronics & Electric Equip.

Entertainment

4,537.0

6,573.0 127.0 1,810.0 0.0 8,501.0

1,380.1 (21.8) 0.0 0.0 1,358.3

2,156.0

Health Care

Industrial & Farm Equip.

Electric8cGasUtilities I 1,268.6 I 0.0 I 0.0 I 0.0 I 1,268.6

961.0 0.0 31.0 0.0 992.0

1,136.0 10.0 0.0 0.0 1,146.0

Motor Vehicles

Petroleum Retining

6,517.1 322.9 249.7 (1,187.9) 5,901.8

6,470.0 491.0 0.0 0.0 6,961.0

302.8

Soaps & Cosmetics

1,195.0

2,645.0 128.0 0.0 0.0 2,773.0

GeneralMerchandise I 2,333.3 I 0.0 I 0.0 I 0.0 I 2,333.3

Insurance: Life & Health (Mutual) I 579.0 I 0.0 I (666.0) I 0.0 (87.0)

2,586.0

288.5

(43.0)


Comprehensive Income: How To Apply the Rules of FASB's Recent Exposure Draft

ascertain what portion of a realized gain or loss was previously unrealized and displayed in other comprehensive income, then the reclassification adjustment is determinable.

The Board decided that reclassification adjustments were practicable for available-for-sale securities and translation adjustments, but that they were not practicable for minimum pension liability adjustments. Therefore, enterprises should display the total change in the balance of other comprehensive income associated with available-for-sale securities and translation adjustments as two amounts: (1) the current period unrealized gains and losses and (2) the reclassification adjustment (the amount of gain or loss realized currently in earnings). Assuming that a portfolio of available-for-sale securities is active, reclassification adjustments will be necessary each period. However, since translation gains and losses are generally only realized upon disposal of a foreign entity, it is unlikely that reclassification amounts will be necessary each period for that item of other comprehensive income.

Using the GE example, and assuming a reclassification amount for securities of ($290) in 1995 and $175 in 1994, the statement of comprehensive income would appear as shown in Exhibit 5.

PREDICTING THE IMPACT Reporting comprehensive income would help enterprises more

clearly depict their financial results to users of financial information

Exhibit 5. Statement of Comprehensive Income with Reclassification Adjustment

General Electric Company and Consolidated Miliates Statement of Comprehensive Income

For the vears ended December 31 (in millions) Net earnings Other comprehensive income:

1995 1994 $6,573 $4,726

Unrealized gains (losses) on investment securities: Unrealized gains (losses) arising during period 2,100* ( 1,833)* Reclassification adjustment for (gains) losses

realized in net earnings (290)" 175* Net unrealized gains (losses) on investment securities 1,810 (1,658)

Total other comprehensive income 1.937 (1.478) Foreign currency translation adjustment - 127 180

Comprehensive income $8.510 $3.248

*This information was not available from GE's financial statements, so the amounts were assumed.


Cheri L. Reither and Panela A. Smith

Should the ED be finalized as proposed, its provisions would be effective for fiscal years beginning after December 15, 1996, with earlier application permitted.

by displaying information, most ofwhich is currently being disclosed, in a more logical and user-friendly format. Reporting items of comprehensive income that are now reported directly in equity in a statement of financial performance would make those items more transparent, more accessible, and more understandable to users of financial statements. In addition, comparability among enterprises would be enhanced by the equalized presentation of other comprehensive income information. The display of comprehensive income in a statement of financial performance also would allow the FASB. to make progress in the financial instruments project by providing a place to report unrealized gains and losses arising from fair value changes. Finally, future FASB projects may progress more expeditiously and efficiently if comprehensive income reporting is in place.

Should the ED be finalized as proposed, its provisions would be effective for fiscal years beginning after December 15, 1996, with earlier application permitted. The ED requires comparative financial statements provided for earlier periods to be restated to reflect its provisions.

The FASB encourages the active participation of all constituent groups in the comprehensive income project and welcomes input from both preparers and users of financial information. The ED is currently in the early stages of its comment period. Copies of the ED may be ordered by calling the FASB order department at (203) 847- 0700, extension 10. +


comprehensive income: how to apply the rules of fasb's recent exposure draft

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