This article explains the current rules and the conceptual debate as to where in the statement of comprehensive income, profits and losses should be recognised – ie when should they be recognised in profit or loss and when in the other comprehensive income. Further, it explores the debate as to whether it is appropriate to recognise profits or losses twice!
The performance of a company is reported in the statement of profit or loss and other comprehensive income. IAS 1, Presentation of Financial Statements, defines profit or loss as ‘the total of income less expenses, excluding the components of other comprehensive income’. Other comprehensive income (OCI) is defined as comprising ‘items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs’. Total comprehensive income is defined as ‘the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners’.
It is a myth, and simply incorrect, to state that only realised gains are included in profit or loss (P/L) 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 P/L and are part of the Retained Earnings (RE). Both such gains are unrealised. The same point could be made with regard to the gains and losses on the financial asset of equity investments. If such financial assets are designated in accordance with IFRS 9, Financial Instruments (IFRS 9), at inception as Fair Value Through Other Comprehensive Income (FVTOCI) then the gains and losses are recognised in OCI and accumulated in equity in OCE. Whereas if management decides not to make this election, then the investment will by default be designated and accounted for as Fair Value Through Profit or Loss (FVTP&L) and the gains and losses are recognised in P/L and become part of RE.
There is at present no overarching accounting theory that justifies or explains in which part of the statement gains and losses should be reported. The IASB’s Conceptual Framework for Financial Reporting is silent on the matter. So rather than have a clear principles based approach what we currently have is a rules based approach to this issue. It is down to individual accounting standards to direct when gains and losses are to be reported in OCI. This is clearly an unsatisfactory approach. It is confusing for users.
In July 2013 the International Accounting Standards Board (IASB) published a discussion paper on its Conceptual Framework for Financial Reporting. This addressed the issue of where to recognise gains and losses. It suggests that the P/L should provide the primary source of information about the return an entity has made on its economic resources in a period. Accordingly the P/L should recognise the results of transactions, consumption and impairments of assets and fulfilment of liabilities in the period in which they occur. In addition the P/L would also recognise changes in the cost of assets and liabilities as well as any gains or losses resulting from their initial recognition. The role of the OCI would then be to support the P/L. Gains and losses would only be recognised in OCI if it made the P&L more relevant. In my view whilst this may be an improvement on the current absence of any guidance it does not provide the clarity and certainty users crave.
Now let us consider the issue of recycling. This is where gains or losses are reclassified from equity to P/L as a reclassification adjustment. In other words gains or losses are first recognised in the OCI and then in a later accounting period also recognised in the P/L. 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 accounting standards to direct when gains and losses are to be reclassified from equity to P/L as a reclassification adjustment. So rather than have a clear principles based approach on recycling what we currently have is a rules based approach to this issue. This is clearly, again, an unsatisfactory approach but also as we shall see one addressed by the July 2013 IASB discussion paper on its Conceptual Framework for Financial Reporting
IAS 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), is one example of a standard that requires gains and losses to be reclassified from equity to P/L as a reclassification adjustment. When a group has an overseas subsidiary a group exchange difference will arise on the re-translation of the subsidiary’s goodwill and net assets. In accordance with IAS 21 such exchange differences are recognised in OCI and so accumulate in OCE. On the disposal of the subsidiary, IAS 21 requires that the net cumulative balance of group exchange differences be reclassified from equity to P&L as a reclassification adjustment – ie the balance of the group exchange differences in OCE is transferred to P/L to form part of the profit on disposal.
IAS 16 PPE is one example of a standard that prohibits gains and losses to be reclassified from equity to P/L as a reclassification adjustment. If we consider land that cost $10m which is treated in accordance with IAS 16 PPE. If the land is subsequently revalued to $12m, then the gain of $2m is recognised in OCI and will be taken to OCE. When in a later period the asset is sold for $13m, IAS 16 PPE specifically requires that the profit on disposal recognised in the P/L is $1m – ie the difference between the sale proceeds of $13m and the carrying value of $12m. The previously recognised gain of $2m is not recycled/reclassified back to P/L as part of the gain on disposal. However the $2m balance in the OCE reserve is now redundant as the asset has been sold and the profit is realised. Accordingly, there will be a transfer in the Statement of Changes in Equity, from the OCE of $2m into RE.
For those who love the double entry let me show you the purchase, the revaluation, the disposal and the transfer to RE in this way.
Dr Land PPE
|Dr Land PPE||2|
|Cr OCE and recognised in OCI||2|
|Cr Land PPE||12|
|Cr Retained earnings||2|
If IAS 16 PPE allowed the reclassification from equity to P&L as a reclassification adjustment, the profit on disposal recognised in P&L would be $3m including the $2m reclassified from equity to P&L and the last two double entries above replaced with the following.
On reclassification from equity to P/L
|Cr Land PPE||12|
IFRS 9 also prohibits the recycling of the gains and losses on FVTOCI investments to P/L on disposal. The no reclassification rule in both IAS 16 PPE and IFRS 9 means that such gains on those assets are only ever reported once in the statement of profit or loss and other comprehensive income – ie are only included once in total comprehensive income. However many users, it appears, rather ignore the total comprehensive income and the OCI and just base their evaluation of a company’s performance on the P/L. These users then find it strange that gains that have become realised from transactions in the accounting period are not fully reported in the P/L of the accounting period. As such we can see the argument in favour of reclassification. With no reclassification the earnings per share will never fully include the gains on the sale of PPE and FVTOCI investments.
The following extract from the statement of comprehensive income summarises the current accounting treatment for which gains and losses are required to be included in OCI and, as required, discloses which gains and losses can and cannot be reclassified back to profit and loss.
Extract from the statement of profit or loss and other comprehensive income
Profit for the year
Other comprehensive income
Gains and losses that cannot be reclassified back to
Changes in revaluation surplus where the revaluation
XX / (XX)
Remeasurements of a net defined benefit liability or
Gains and losses on remeasuring FVTOCI financial
Gains and losses that can be reclassified back to profit or loss
Group exchange differences from translating functional currencies into presentation currency in accordance with IAS 21
The effective portion of gains and losses on hedging instruments in a cash flow hedge under IFRS 9
Total comprehensive income
XX / (XX)
In the July 2013 discussion paper on the Conceptual Framework for Financial Reporting the role of the OCI and the reclassification from equity to P/L is debated.
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 P/L and OCI. This would reduce complexity and gains and losses could only ever be recognised once. There would still remain the issue of how to define the earnings in earnings per share, a ratio loved by 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 P/L.
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 P/L. As such, by recognising the revaluation surplus in OCI, the OCI is acting as a bridge between the statement of financial position and the P/L. On disposal reclassification ensures that the amount recognised in P/L will be consistent with the amounts that would be recognised in P/L 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 P/L of a future accounting period. Only by recognising the effective gain or loss in OCI and allowing it to be reclassified from equity to P/L 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 IASB would decide in each IFRS 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.
Whilst the IASB has not yet determined which approach will be adopted, its chairman Hans Hoogervorst has gone on the record as saying ‘It is absolutely vital that the P/L contains all information that can be relevant to investors and that nothing of importance gets left out… and… the IASB should be very disciplined in its use of OCI as resorting to OCI too easily would undermine the credibility of net income so the OCI should only be used as an instrument of last resort’. Now that sounds like a personal endorsement of the narrow approach to me!
Tom Clendon is a lecturer at FTMS based in Singapore and is the author of the second edition of A Student's Guide to Group Accounts (published by Kaplan Publishing)