New Rules on Comprehensive Income Lead to Head-Scratching

Companies are finding it tougher than they expected to transfer equity to earnings in the way required by a new accounting rule, prompting the Financial Accounting Standards Board to defer an aspect of the rule while they try to sort out the problem. 

The issue surfaced as companies prepared to start complying with Accounting Standards Update No. 2011-05 Comprehensive Income, which takes effect for calendar-year companies at the start of 2012. The thrust of the new standard seems straightforward enough: It eliminates one of three long-allowed options for how to display “other comprehensive income” in financial statements. In effect, companies can no longer fold OCI into their statement of shareholder's equity, which is currently the most common method. Instead, they must display it on the face of the income statement or in a separate statement immediately following the income statement.

That's where problems arise. Companies are finding that transferring equity to earnings in the way the new rule requires is much harder than expected.

OCI represents gains and losses that have not yet been realized, explains Adam Brown, a partner with audit firm BDO USA. For example, when a company revises the value of an investment (a bond, say) each reporting period, the difference is often reflected in OCI, which is part of equity. The change in value affects the asset side of the balance sheet, so the change to OCI represents the offset to equity.

“If I ever sell that bond, I'm going to make money or lose money on that investment,” Brown explains. “When I do, all of those prior adjustments will get reclassified. I take them out of equity and put them in the income statement on the date I sell them. That's when I reap the benefits.” The concept has become known in accounting as “recycling.”

Under current accounting rules, a number of such gains and losses can be recorded through OCI, then recycled into net income when the gain or loss is ultimately realized, says Mike Loritz, a shareholder at audit firm Mayer Hoffman McCann. The big ones, aside from changes in investment values, are changes in pensions and other post-retirement benefits, certain derivatives, and foreign currency translation adjustments, he says.

Foreign currency adjustments can arise when a U.S. company consolidates the results of a foreign subsidiary that uses a different currency, such as Euros or the Yen. “When you consolidate that entity, you have to translate all those assets and liabilities into U.S. dollars,” Loritz says; the gains or losses are recorded in OCI. “It sits there forever until you sell or dispose of that subsidiary, then you recognize the gain or loss in earnings.”

Accounting rules have long allowed actuarial gains or losses tied to pension plans to be recorded in OCI to smooth out the ups and downs associated with those plans so they wouldn't whipsaw earnings. The thinking behind the rules is that it's a long-term liability, so that volatility shouldn't directly affect earnings, Brown says. “The way you do that mechanically is through OCI,” he says.

Down the Road

“It's a garbage dump. When FASB doesn't know what to do with something, they throw it into adjusted OCI.”

—Mike Loritz,

Shareholder,

Mayer Hoffman McCann

The list of items that would be subject to such recycling is expected to grow when FASB eventually finishes its high-profile, controversial standard on financial instruments. In fact, FASB adopted the new OCI standard in anticipation of the new requirements for financial instruments. With the OCI balance expected to grow under the new financial instrument requirements, FASB wanted investors to get a better look at it, so they wanted the number to be more prominent in financial statements.

Companies are familiar with how to reclassify such items to transfer them from equity to earnings; the problem is the standard's provisions about presentation. The OCI standard requires separate presentation on the face of the financial statements for items reclassified from OCI into net income within both the net income and the OCI sections of the financial statements.

FEI LETTER TO FASB

Below is an excerpt from the FEI's Committee on Corporate Reporting letter to FASB Chairman Leslie Seidman regarding other comprehensive income:

1. Availability of information for separate presentation of reclassification adjustments in the statement of earnings.

CCR could understand how this information might be assumed to be readily available since it is literally the other side of the reclassification journal entry. In practice, however, the offsets are known at the level in the reporting structure where the journal entries are made. In a decentralized reporting environment, such work frequently is distributed among hundreds of reporting components. Since there was no pre-existing requirement to capture and report this information, many of our members have indicated that this data is not currently available at the consolidated level without some form of supplemental data collection effort.

For many of our member companies, this issue is exacerbated by the fact that some or all of these reclassifications may be capitalized for some period of time (e.g., as part of the cost of finished goods inventory or as a capitalizable element of fixed assets). Those entities indicate that tracking and reporting mechanisms do not presently exist to determine when and how these adjustments are recycled through earnings. Those companies indicate that, at a minimum, they will need additional time to develop such mechanisms and they have raised questions regarding the cost-benefit of implementing such mechanisms.

While the Board may ultimately conclude that it still intends to require disclosure of reclassification adjustments affecting the statement of earnings, we believe that it will be necessary to give reporting entities more time to comply and that the Board should provide the option to report this information outside of the statement of earnings. These matters are further discussed below.

2. Interim reporting requirements

CCR observes that because interim statements are permitted to be more condensed than annual statements, the likelihood that the earnings statement captions would be the same for interim and annual statements is considerably less than 100%. In those circumstances in which the interims are highly condensed, the disclosure of the OCI reclassification components is unlikely to be very useful. In addition, given the time constraints and issues raised in point (1) above, the added challenge of collecting, analyzing and reporting this information during considerably shorter interim reporting cycles argues in favor of this being a requirement that should apply only to annual statements.

CCR observes that the amendments to the Interim Period Reporting guidance in the ASU appear to provide for more modest changes to the existing requirement to report the total of comprehensive income in the notes. The amended ASU reads as follows:

Interim-Period Reporting

220-10-45-18 Subtopic 270-10 clarifies the application of accounting principles and reporting practices to interim financial information, including interim financial statements and summarized interim financial data of publicly traded companies issued for external reporting purposes. An entity shall report the components of net income and other comprehensive income and total for comprehensive income in condensed financial statements of interim periods.

Based on the nature of the amendments above, CCR believes that the Board has discretion to ameliorate the burden and difficulty of this requirement depending on how it chooses to clarify what is expected to be reported in interim statements. For example, if the Board decides not to mandate the same level of reporting in both interim and annual statements, these new reporting requirements would be much more manageable from an interim standpoint. As the SEC has historically provided additional guidance on the form and content of interim financial statements, we have included the SEC Staff in the distribution of this letter.

Source: FEI CCR OCI Letter to FASB.

According to an alert from KPMG, the separate presentation of reclassification adjustments may be difficult because some reclassification adjustments don't transfer neatly to a single line item in net income. As an example, the firm says the amortization of actuarial gains or losses associated with a defined benefit pension plan might affect numerous line items. It could hit the cost of goods sold; research and development expense; or selling, general, and administrative expense—all of which appear in net income. It might also be included in inventory or self-constructed property, plant, and equipment, which are in the statement of financial position.

John Hepp, a partner with audit firm Grant Thornton, says companies may find they don't have the information captured in a way that lends itself to the new required presentation. With pension plans for example, the data may reside in separate reporting units or even third-party pension plan administrators where it may not be collected and easily transferred in the manner now required, he says.

The new presentation has also led to some concerns about complexity, Loretta Cangialosi, chairman of the committee on corporate reporting for Financial Executives International, wrote in a letter to FASB. Companies have mocked up new income statements showing the presentation of reclassification adjustments, and they worry the result is too complicated. “The draft earnings statements of our member companies look very complex, having many new line items and sub-totals,” she wrote. She's worried investors will get lost in the detailed disclosure elements.

In her letter, Cangialosi suggests FASB take a hard look at whether the presentation of classification adjustments should be handled in some other way, such as through footnotes or other methods, rather than in the body of the earnings statement. She notes International Financial Reporting Standards allows companies more options.

FASB has said it will defer the reclassification requirement, but it is not reconsidering the effective date for the new OCI geography. Companies will still be required to present OCI immediately after net income in the income statement or in a separate statement immediately following the income statement.

The OCI bucket has been the subject of accounting curiosity for years, with accounting rules offering no clear conceptual underpinnings for why it exists. “It's a garbage dump,” says Loritz. “When FASB doesn't know what to do with something, they throw it into adjusted OCI.”

According to Brown, the plan to develop new accounting rules for financial instruments will surely increase the volume of activity in OCI. FASB plans to require more instruments to be recorded at fair value, but as a compromise to critics, some changes will be recorded in OCI instead of net income, he says.