Is a second income statement needed?

Reporting comprehensive income could enhance the understandability of financial statements.

The Financial Accounting Standards Board is considering whether to establish a vehicle for reporting comprehensive income defined as all non-owner changes in equity that would augment or supplement the traditional income statement. It could take the form of either a second income statement or an expanded version of the traditional statement. The drive to report comprehensive income is fast gaining momentum at the FASB, in part because of issues related to the board's financial instruments project.

The FASB determined that constituents need fair value information about financial instruments and took the first steps by requiring disclosure of such information in Statement no. 107, Disclosures about Fair Value of Financial Instruments, and Statement no. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. However, requiring disclosure of fair value information in the notes to the financial statements is not entirely satisfactory. Those pronouncements have substantially increased footnote disclosures, thus contributing to what some constituents perceive as disclosure overload.

Maintaining historical cost measures in the financial statements themselves is not entirely satisfactory either (particularly in balance sheets) because many instruments are obtained without explicit cost and hence are "off balance sheet." Interest rate swaps, for example, do not generally involve an exchange of cash at the contract's inception and therefore are not recognized on the balance sheet. However, measuring financial instruments at fair value in balance sheets would result in more volatile income statements if gains and losses resulting from changes in their fair values were recognized. What is the solution? Report those changes in a vehicle that would complement--but not replace--the traditional income statement.

WHAT IS COMPREHENSIVE INCOME AND WHY REPORT IT?

Comprehensive income is defined by the FASB 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 distributions to owners." While the FASB concluded in its concepts statements that a full set of financial statements for a period should show comprehensive income for the period, they have not yet required business enterprises to report it.

The FASB and its predecessor, the Accounting Principles Board, both embrace the all-inclusive income concept as the foundation for reporting. However, the FASB's adherence to that concept gradually eroded in Statement no. 12, Accounting for Certain Marketable Securities, Statement no. 52, Foreign Currency Translation, Statement no. 80, Accounting for Futures Contracts, Statement no. 87, Employers' Accounting for Pensions, and Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities, in which certain income items are reported directly in equity. If more items are taken directly to equity--as is likely without another means of reporting comprehensive income--equity will become a dumpster for an amorphous and growing mass of important information. Thus, the more different items there are in non-owner changes to equity, the more important it becomes to have a statement that displays them in an organized way on their way to becoming equity.

Reporting comprehensive income may help resolve some difficult and challenging financial reporting issues, particularly in the area of financial instruments, because the way certain issues involving recognition and measurement are resolved often hinges on whether and when items are to be reported in net income. For example, Statement no. 115 links how securities are classified (as trading, available-for-sale or held-to-maturity) to how they are to be measured as well as to where and when gains and losses on those securities are to be reported. Distinguishing between trading and available-for-sale securities affects where unrealized gains and losses are to be reported. In addition, distinguishing between those securities and held-to-maturity securities affects whether or not unrealized gains and losses are to be reported.

Proponents of reporting comprehensive income include the Association for Investment Management and Research (AIMR), one of the largest and most influential user groups. In its 1993 report, Financial Reporting in the I990s and Beyond, the AIMR urged the FASB to construct the bridge from concept to standard for comprehensive income. The AIMR believes comprehensive income is needed for better and more useful financial reporting in several areas, including reporting the impact of changing fair values of marketable securities and all other nonowner changes in equity that currently are reported as equity adjustments.

The need to report financial instruments at fair value on the balance sheet while preserving the traditional measure of income in the income statement creates a dilemma for the FASB. Although measuring financial instruments at fair value results in recognizing gains and losses on those instruments, it does not necessarily follow that those gains and losses must be reported in a traditional income statement. Indeed, the FASB concepts statements acknowledge the possibility of including some gains and losses in an income statement and excluding others from net income and reporting them elsewhere as a part of comprehensive income. Developing a new vehicle for reporting those items would bridge that gap. Some examples of non-owner changes in equity that currently are excluded from net income are listed in exhibit 1, page 70.

REPORTING COMPREHENSIVE INCOME

Comprehensive income could be reported in a variety of ways. One would be to use a newly created statement of comprehensive income that has "total comprehensive income" as its bottom line. This format would preserve the traditional income statement with its bottom line of net income. Moreover, displaying comprehensive income in a separate new statement that is in addition to a traditional income statement would accord its components equal status with the traditional income statement's components. In addition, the income statement's relationship to the new statement could be made apparent by starting the new statement with the bottom line amount from the traditional statement.

That approach is illustrated in exhibit 2, at right, and is based on one year of data for a company that has a portfolio of available-for-sale equity securities with both unrealized and realized gains and dividend income. Because available-for-sale securities are financial instruments, they afford the opportunity of using an existing requirement--Statement no. 115--for a particular class of financial instrument to highlight how comprehensive income might be reported.

Of course, other formats for reporting comprehensive income might be appropriate. For example, instead of displaying both a traditional income statement and a new statement of comprehensive income, the information could be combined into a single statement in which the traditional statement's bottom line would be a subtotal with total comprehensive income as a final total. This format has the advantage of not requiring the creation of a new financial statement. However, relegating net income to a subtotal might be perceived by some as a disadvantage.

Still another alternative would be a three-column statement with one column for the components of a traditional income statement, a second column for other components of comprehensive income and a third column combining the first two. The advantage would be in the ease of comparison offered by the side-by-side display. It also affords net income and comprehensive income equal status since they would be presented in the same fashion.

ENHANCING UNDERSTANDABILITY

Reporting comprehensive income in either a second statement of income or an expanded income statement would provide a vehicle for reporting income items that presently bypass a traditional income statement and go directly to equity. With this vehicle in place, the understandability of financial statements would be enhanced for investors, creditors and other users because income items now reported directly in equity would be reported in a formal, more organized statement of comprehensive income.

Because those items are too relevant to be tucked away as direct increases and decreases in equity, the FASB has added a project to its agenda to address the reporting of comprehensive income. As with other FASB projects, it is subject to an extensive due process that is open to public observation and participation. An exposure draft with the board's decisions to date is expected by mid-1996.

Exhibit 1: Non-owner Changes in Equity Excluded from Net Income

* Foreign currency translation adjustments (FASB Statement no. 52, Foreign Currency Translation).

* Gains and losses on foreign currency transactions designated as, and effective as, economic hedges of a net investment in a foreign entity, commencing as of the designation date (Statement no. 52).

* Gains and losses on intercompany foreign currency transactions that are of a long-term investment nature (that is, settlement is not planned or anticipated in the foreseeable future), when the parties to the transaction are consolidated, combined or accounted for by the equity method in the reporting enterprise's financial statements (Statement no. 52).

* A change in the market value of a futures contract that qualifies as a hedge of an asset reported at fair value unless the events specified in paragraph 11 require earlier recognition of a gain or loss in income became there is not a high correlation (Statement no. 80, Accounting for Futures Contracts).

* The excess of the additional pension liability over unrecognized prior service cost--net loss not yet recognized as net periodic pension cost--(Statement no. 87, Employers' Accounting for Pensions).

* Unrealized holding gains and losses on available-for-sale securities (Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities).

* Unrealized holding gains and losses that result from a debt security being transferred into the available-for-sale category from the held-to-maturity category (Statement no. 115).

* Subsequent increases in the fair value of available-for-sale securities previously written down as impaired (Statement no. 115).

* Subsequent decreases in the fair value of available-for-sale securities--if not an other-than-temporary impairment--previously written down as impaired (Statement no. 115).

EXECUTIVE SUMMARY

* THE FINANCIAL ACCOUNTING Standards Board is considering establishing a vehicle for reporting comprehensive income--all non-owner changes in equity. This so-called second income statement might also take the form of an expanded version of the traditional statement.

* COMPREHENSIVE INCOME INCLUDES ALL equity changes during a period except those resulting from investments by owners and distributions to owners. Reporting it may resolve some challenging financial reporting issues, particularly in the area of financial instruments.

* THERE ARE A VARIETY OF WAYS TO report comprehensive income. One would use a newly created income statement, while preserving the traditional statement. The information also could be combined into a single statement so an entirely new one does not have to be created. Another alternative is a three-column statement with components of traditional income in one column, other components of comprehensive income in a second column and a third column combining the first two.

* REGARDLESS OF WHICH OPTION IS selected, the understandability of financial statements would be enhanced because a vehicle would be provided for reporting income items that presently bypass a traditional statement and go directly to equity.

DENNIS R. BEKESFORD, CPA, CMA, is chairman of the Financial Accounting Standards Board in Norwalk, Connecticut. L. TODD JOHNSON, CPA, PhD, is a research manager with the FASB. CHERI L. REITHER, CPA, CMA, PhD, is an assistant project manager with the FASB.

The Financial Accounting Standards Board encourages expressions of individual views of board members and staff. The views in this article are those of the authors. Official FASB positions on accounting matters are determined only after extensive due process and deliberation.

Exhibit 2: Example of Comperhensive Income Statement

On January 1, 1995, company X had cash and common stock of $50,000. At that date the company had no other asset, liability or equity balances. On January 2, company X purchased for cash $50,000 of equity securities that it classified as available-for-sale. On June 30, company X sold part of the available-for-sale portfolio, realizing a gain.

  Fair value of securities sold           $22,000
        Less: Cost of securities sold            20,000
        Realized gain                           $ 2,000
  Company X did not purchase or sell any other securities during
  1995. It received $3,000 in dividends. At December 31, 1995,
  the remaining portfolio is
        Fair value                              $34,000
        Less: Cost                               30,000
        Unrealized gain                         $ 4,000

                      Income Statement
                  Year ended December 31, 1995

        Revenues, expenses, etc.
        Dividend income                         $3,000
        Realized gains on
         investments in securities               2,000
          Net income                            $5,000

                Statement of Comprehensive Income
                  Year ended December 31, 1995

        Net income                              $5,000
        Total gains arising
         during period         $6,000
        Less: Gains realized
         in net income         (2,000)           4,000

        Comprehensive income                    $9,000

                Statement of Changes in Shareholders' Equity
                  Year ended December 31, 1995

                                   Accumulated other
            Common     Retained     comprehensive
            stock      earnings     income                Total

Beginning
  balance   $50,000                                      $50,000

Add: Net income        $5,000                              5,000
  Other                             $4,000                 4,000

Ending
  balance   $50,000    $5,000       $4,000               $59,000

                Comparative Statement of Financial Position
                             December 31, 1995

                            1/1/95           12/31/95
Assets:
       Cash                $50,000           $25,000

       Securities                             34,000
       Total assets        $50,000           $59,000

Shareholders' equity
       Common stock        $50,000           $50,000

       Retained earnings                       5,000
       Accumulated other
         comprehensive income                  4,000
          Total shareholders'
            equity         $50,000           $59,000