This article looks at what differentiates profit or loss from other comprehensive income and where items should be presented.
The purpose of the statement of profit or loss and other comprehensive income (PLOCI) is to show an entity’s financial performance in a way that is useful to a wide range of users. The statement should be classified and aggregated in a manner that makes it understandable and comparable. International Financial Reporting Standards (IFRS® standards) currently require the statement to be presented as either a single statement, with profit or loss and other comprehensive income presented as two sections in that order or two statements, being the statement of profit or loss and the statement of comprehensive income (OCI). An entity may refer to the combined statement as the Statement of comprehensive income. An entity has to show separately in OCI, those items which would be reclassified subsequently (‘recycled’) to profit or loss and those items which would never be reclassified subsequently (‘recycled’) to profit or loss. The related tax effects have to be allocated to these sections.
IAS 1 provides illustrative examples of the presentations including the following:
Profit or loss includes all items of income or expense (including reclassification adjustments) except those items of income or expense that are recognised in OCI as required or permitted by IFRS standards. Reclassification adjustments are amounts recognised to profit or loss in the current period that were previously recognised in OCI in the current or previous periods. Examples of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cash flow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16® , Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits. These are illustrated in the example from IAS 1 above.
However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified. A common misunderstanding is that the distinction is based upon realised versus unrealised gains. It is simply incorrect, to state that only realised gains are included in the statement of profit or loss (SOPL) and that only unrealised gains and losses are included in the OCI. For example, gains on the revaluation of land and buildings accounted for in accordance with IAS 16, Property Plant and Equipment (IAS 16 PPE), are recognised in OCI and accumulate in equity in Other Components of Equity (OCE). On the other hand, gains on the revaluation of land and buildings accounted for in accordance with IAS 40, Investment Properties, are recognised in SOPL and accumulate in equity as part of the Retained Earnings (RE). Both such gains are unrealised.
This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS standards. It may be difficult to deal with OCI on a conceptual level since the International Accounting Standards Board (the Board) is finding it difficult to find a sound conceptual basis. At present it is down to individual accounting standards to direct when gains and losses are to be reported in OCI However, there is urgent need for some guidance around this issue.
In March 2018 the Board published its Conceptual Framework for Financial Reporting. This addressed the issue of where to recognise gains and losses. It suggests that the SOPL should provide the primary source of information about the entity’s financial performance for the reporting period. Accordingly the SOPL should recognise all income and expenses. However, the Board may also provide exceptional circumstances where income or expenses arising from the change in the carrying amount of an asset or liability should be included in OCI. This will usually occur to allow the SOPL to provide more relevant information or provide a more faithful representation of an entity’s performance. Whilst this may be an improvement on the absence of general principles, it might be argued that it does not provide the clarity and certainty users crave.
‘Recycling’ is the process whereby items previously recognised in other comprehensive income are subsequently reclassified to profit or loss.as an accounting adjustment but referred to in IAS 1 as reclassification adjustments.. In other words gains or losses are first recognised in the OCI and then in a later accounting period also recognised in the SOPL. In this way the gain or loss is reported in the total comprehensive income of two accounting periods and in colloquial terms is said to be ‘recycled’ as it is recognised twice. At present it is down to individual IFRS standards to direct when gains and losses are to be reclassified from OCI to SOPL as a reclassification adjustment. So rather than have a clear principles based approach on reclassification what we currently have is a rules based approach to this issue.
There are several arguments for and against reclassification from OCI to SOPL. If reclassification ceased, then there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRS standards. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS standards permit similar items to be recognised in either profit or loss or OCI.
Those against reclassification argue that the recycled amounts add to the complexity of financial reporting, may lead to earnings management and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period.
The original logic for OCI was that it kept income-relevant items that possessed low reliability from contaminating the earnings number (profit for the year). Markets rely on profit or loss and it is widely used. The OCI figure is crucial however it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of the profit for the year figure and key investor ratios used by stakeholders to assess an entities performance. The use of OCI as a temporary holding for cash flow hedging instruments and foreign currency translation is non-controversial and widely understood. These will be reclassified in a future accounting period therefore impacting profit or loss.
However, other treatments such the policy of IFRS 9 to allow value changes in equity investments to go through OCI (by making the appropriate election), are not as widely understood or accepted by stakeholders who feel this can make comparability more challenging even though the qains and losses will also be reclassified to profit or loss on dereognition of the asset.
There are three different approaches to reclassification: ignore all possible reclassifications; permit only a few reclassifications (narrow approach) or permit all reclassifications if they provide useful information (broad approach).
It can be argued that reclassification should simply be prohibited. This would free the statement of profit or loss and other comprehensive income from the need to formally to classify gains and losses between SOPL and OCI. This would reduce complexity and gains and losses could only ever be recognised once. However, there would still remain the issue of how to define the earnings in earnings per share, a very important ratio for investors, as clearly total comprehensive income would contain too many gains and losses that were non-operational, unrealised, outside the control of management and not relating to the accounting period.
Another suggestion is that the OCI should be restricted, should adopt a narrow approach. On this basis only bridging and mismatch gains and losses should be included in OCI and be reclassified from equity to SOPL.
A revaluation surplus on a financial asset classified as FVTOCI is a good example of a bridging gain. The asset is accounted for at fair value on the statement of financial position but effectively at cost in SOPL. As such, by recognising the revaluation surplus in OCI, the OCI is acting as a bridge between the statement of financial position and the SOPL. On disposal, reclassification ensures that the amount recognised in SOPL will be consistent with the amounts that would be recognised in SOPL if the financial asset had been measured at amortised cost.
The effective gain or loss on a cash flow hedge of a future transaction is an example of a mismatch gain or loss as it relates to a transaction in a future accounting period so needs to be carried forward so that it can be matched in the SOPL of a future accounting period. Only by recognising the effective gain or loss in OCI and allowing it to be reclassified from equity to SOPL can users to see the results of the hedging relationship.
A third proposition is for the OCI to adopt a broad approach, by also including transitory gains and losses. The Board would decide in each IFRS standard whether a transitory remeasurement should be subsequently recycled.
Examples of transitory gains and losses are those that arise on the remeasurement of defined benefit pension funds and revaluation surpluses on PPE.
The Board has adopted the latter approach in its March 2018 Conceptual Framework for Financial Reporting stating that reclassifications from OCI to SOPL are permitted '…in a future period when doing so results in the [SOPL] providing more relevant information, or providing a more faithful representation of the entity’s financial performance for that future period'. However, if there is no clear basis to identify the period or the amount that should be reclassified, the Board, when developing IFRS standards, may decide that no classification should occur.
Updated by a member of the DipIFR examining team