Comprehensive income reporting concerns.

Mautz, R. David, Jr. ; Robinson-Backmon, Ida

ABSTRACT

Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, requires presentation of comprehensive income as part of a complete set of financial statements. However, researchers, members of the financial community, and even some members of the Financial Accounting Standards Board, have expressed concerns about the effectiveness of the new standard. This article reports survey results that confirm and amplify several concerns. In particular, accounting academics and financial executives are concerned that the reporting standards allow too much latitude and are likely to lead to confusion among financial statement readers. Respondents also express concern about the cost of preparing comprehensive income disclosures and the potential for management to downplay poor results by reporting comprehensive income in the stockholders' equity statement. The Financial Accounting Standards Board is urged to reduce the reporting alternatives available to companies and to undertake a review of the burgeoning array of performance measures reported in financial statements.

INTRODUCTION

In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, which requires presentation of comprehensive income as part of a complete set of financial statements. The objectives of the new standard include providing a comprehensive framework for presenting all non-owner changes in equity and raising the visibility of items previously reported only as adjustments to equity. This article summarizes recent research and reports on a survey of academic accountants and practicing financial professionals. The results suggest that the FASB should consider refining SFAS No. 130 to insure that the new disclosures succeed in expanding users' focus beyond the traditional bottom line.

COMPREHENSIVE INCOME: A LITTLE HISTORY

Accountants, managers and standard setters have debated which items should be included in income, and which should be reported as direct adjustments to equity. At one extreme, a "current operating performance" definition of income includes only operating items. Non-operating results are reported as direct adjustments to retained earnings. Under an "all-inclusive" definition, only investments by owners and dividends are excluded from net income. The general trend among U.S. standard setters has been to favor an all-inclusive definition of income.

Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, provided the foundation for SFAS No. 130 with this definition of an all-inclusive measure termed comprehensive income:

 ... the change in equity [net assets] 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 (FASB, 1985, para. 70).

Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises, asserted that comprehensive income should be reported as part of a complete set of financial statements. No such requirement was initially imposed. However, the list of non-owner changes in equity excluded from net income grew to include unrealized gains and losses arising from investments in marketable securities, foreign currency translation, futures contracts, and employers' pension liabilities. SFAS No. 130 was issued in 1997 to provide framework for reporting these and other unrealized gains and losses.

EARLY MISGIVINGS ABOUT SFAS NO. 130

Even as the FASB required disclosure of comprehensive income, some questioned whether the reporting and display requirements of SFAS No. 130 would achieve the Board's objectives. In their dissenting opinion, Board members Cope and Foster expressed dissatisfaction that net income may be displayed more prominently in the financial statements than other components of comprehensive income. The primary objectives of reporting comprehensive income, include raising the visibility of other items of comprehensive income relative to net income and combating users' fixation on net income and earnings per share.

Research findings have also raised questions about comprehensive income reporting requirements. Dhaliwal, et al. (1999) find no evidence that comprehensive income adds to the information conveyed by net income. Hirst & Hopkins (1998) report that comprehensive income can help analysts detect attempts to manage reported earnings through judicious management of the marketable equity securities portfolio. However, the disclosures are fully effective only when reported in a separate statement of comprehensive income or combined with the income statement. Maines & McDaniel (2000) report that display format display format has no apparent impact on investors' acquisition or evaluation of unrealized gain information reported as part of other comprehensive income. However, investors place significant weight on their assessments when the information is reported in a statement of comprehensive income, but not when the information is presented in a statement of stockholders' equity.

The reporting practices of companies who adopted SFAS No.l30 early raise additional concerns. Campbell, et al. (1999) review the annual reports of 73 companies that adopted SFAS No. 130 before the required implementation date. They find that more than half reported comprehensive income in the statement of stockholders' equity. The impact of comprehensive income among these companies was material and negative. Companies whose comprehensive income was materially positive were more likely to either prepare a combined statement of income and comprehensive income or present a separate comprehensive income statement.

The early evidence suggests that display format matters, and that companies use format to manipulate the prominence of comprehensive income in the financial statements. These issues will affect even more companies as the application of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, gives rise to more components of other comprehensive income (Jones & Wilson, 2000). Businesses are also concerned with the potential reporting burden of SFAS No. 130. One recent article explained how companies can restructure their marketable equity securities portfolio to avoid implementing SFAS No. 130 (Godwin & Alderman, 1999).

CONCERNS EXPRESSED BY FINANCIAL PROFESSIONALS

The remainder of this article reports on a survey of practicing financial professionals and academic accountants. These financial professionals also express concerns about the requirements of SFAS No. 130. Survey respondents are particularly concerned that: (1) reporting requirements will prove burdensome, (2) display format alternatives permitted under SFAS No. 130 will impair usefulness, and (3) users will be confused by the growing number of alternative "bottom lines."

Responses were obtained from 64 accounting faculty members and 111 chief financial officers and financial analysts. Both groups were educated in relevant disciplines, possessed considerable professional experience, and were familiar with financial reporting practices. Average experience among practitioners was 23 years. More than half held advanced degrees; most had been educated in accounting, finance or economics. Nearly half were CPAs, and many held various professional credentials including law degrees and securities licenses. All 111 responded that they analyze financial statements at least occasionally; the vast majority (86%) indicated that they do so regularly or often.

The accounting faculty had similar experience-21 years on average. Virtually all reported formal education in accounting. Nearly 90% held a doctorate, and the majority were CPAs. Predictably, the faculty prepare and analyze financial statements less often.

AN OVERVIEW OF OPINIONS

Participants indicated agreement or disagreement with questions about comprehensive income reporting on six-point scales ranging from strongly disagree (1) to strongly agree (6). Respondents also weighed the costs and benefits of comprehensive income reporting and expressed their display format preferences. These responses are summarized in Table 1.

Both groups expressed moderate familiarity with SFAS No. 130. Academics were more familiar with, and more impressed by, comprehensive income reporting. Professors generally believed that comprehensive income reporting assists in predicting future cash flows. Practitioners were less confident of predictive ability and more concerned about the potential reporting burden. Both were concerned that comprehensive income will confuse financial statement readers. With regard to overall costs and benefits, academics were again more positive. Fifty three percent of academic respondents believe that the benefits of reporting comprehensive income outweigh the costs. Only 17% responded that costs outweigh benefits. The pattern among practitioners was exactly opposite. Forty-one percent responded that costs outweigh benefits. Only 27% believed that SFAS No. 130 makes sense from a cost/benefit standpoint.

Differences of opinion were also evident in preferences for reporting format. Academics overwhelmingly favored reporting comprehensive income in one of the two formats preferred by the FASB, either a combined statement with net income or a separate statement of comprehensive income. Only 12% favored reporting comprehensive income in the statement of stockholders' equity. Practitioners were more evenly divided, with nearly a third preferring the stockholders' equity alternative.

EVALUATING COMPONENTS OF NET INCOME AND COMPREHENSIVE INCOME

To gain insight into the relative usefulness of various net income and comprehensive income components, respondents were asked to make six judgments about decision usefulness. The judgments were coded on six point scales ranging from strongly disagree (1) to strongly agree (6).

The specific judgments were:

1. Conveys important economic information

2. Is relevant to many judgments and decisions

3. Is an indicator of management performance

4. Should be included in net income

5. Should be reported as a separate line item

6. Should be reported on a per share basis.

The items evaluated included four elements of net income, comprehensive income, and three of its components:

Elements of Net Income:
 Income or Loss from Continuing Operations
 Gain or Loss from Discontinued Operations
 Extraordinary Gain or Loss
 Cumulative Effect of an Accounting Change.

Comprehensive Income and Its Components:
 Foreign Currency Translation Adjustment
 Unrealized Security Holding Gain or Loss
 Minimum Pension Liability Adjustment

Table 2 reports means and standard deviations for the resulting assessments. Responses from academics and practitioners were qualitatively similar and are aggregated.

The first three questions measure usefulness without regard to current reporting standards. The latter three also measure usefulness, but responses to these questions may be influenced by knowledge of current GAAP. For example, the fact that income from continuing operations is currently reported on a per share basis may induce greater agreement with the statement that income from continuing operations should be reported on a per-share basis.

An overall usefulness score was computed for each item by averaging scores across all six questions. These scores are described in the "Overall" column at the right side of Table 3. The grand means leave no doubt that net income is the key performance measure. The mean score for all net income items on all six questions is 4.61. For comprehensive income and its components, the corresponding score is 3.56. Income from continuing operations (5.27) stands out from all other items. Comprehensive income (3.65) and its components receive much lower evaluations. Three-question scores are computed using only questions that could be answered independently of current reporting standards. The results are qualitatively similar. Net income (grand mean = 4.45) is more important than comprehensive income (grand mean = 3.77). Income from continuing operations (5.30), discontinued operations (4.51), and extraordinary items (4.27) are all evaluated more favorably than comprehensive income or its elements. The highest scoring comprehensive income item is unrealized security holding gain or loss (4.00).

A final analysis involved ranking the eight items, question-by-question. These results are reported in Table 3. Again, the academic and practitioner responses are combined.

Several general conclusions are evident in Table 3. First, income from continuing operations, discontinued operations, and extraordinary items dominate any assessment of usefulness. These items are ranked first, second or third on every dimension. The cumulative effect of a change in accounting principle is clearly less important, but respondents believe that it should continue to be reported as a line-item component of net income and disclosed on a per-share basis.

Comprehensive income scores toward the bottom on every dimension except as an indicator of management performance. There is also support for presenting comprehensive income on a per-share basis. Unrealized security holding gain or loss consistently ranks near the net income components in terms of usefulness. There is little support, however, for reporting it as a part of net income or on a per-share basis. Minimum pension liability adjustments rank last on every question.

BENEFITS, DRAWBACKS AND THE "BOTTOM LINE"

The final section of the questionnaire asked open-ended questions beginning with a request to complete this statement: "If asked to identify a single 'bottom line' that would be useful for most financial statement readers, I would select--." The responses summarized in Table 4 again confirm the dominance of net income. Over 80% named some component of net income; almost half chose operating income.

The principal benefits identified with reporting comprehensive income fall heavily into two categories. A third of those answering cite improvements in disclosure and detail. Typical remarks mention more detailed information for analysis, improved visibility for items that go directly to equity, and highlighting significant unrealized gains/losses on securities. A similar number assert that comprehensive income helps in understanding the economic picture sufficiently to forecast the future. Responses mention improved awareness of items that will affect income in the future, allowing better estimates of future cash flows, and obtaining a better forward view of company results. A minority assert that users, particularly sophisticated users, will understand the company's results better with the additional information. Only one response asserted that reporting comprehensive income provides no benefit.

Academics and practitioners agree that the most likely drawback to reporting comprehensive income lies in its potential to confuse readers. More than half the responses make reference to this problem. Concerns include making management look better or worse due to items beyond their control, providing excessive detail, and the proliferation of competing income numbers. Practitioners are also concerned about the time and cost necessary to prepare the new disclosures.

Finally, participants were invited to express thoughts that they would like to share with standard setters. The single most prevalent comment from both academics (36%) and practitioners (54%) urged the FASB to simplify reporting requirements to avoid confusing financial statement readers. Among academics, the second most common comment (27%) supported the Board's efforts, praising the comprehensive income standard. Those in practice were less enthused. Twenty-two percent asserted that SFAS No. 130 does little or nothing to improve financial reporting. A common complaint was that the final version of the standard was "watered down." One respondent asserted that reporting comprehensive income "avoids the more important issue of what should be included in net income."

CONCLUSIONS

Members of the financial community, accounting researchers, and even some members of the Financial Accounting Standards Board have expressed concerns about the effectiveness of comprehensive income reporting under SFAS No. 130. The alternative display formats permitted are a particular source of concern among those who fear that reporting different "classes" of income impairs the effort to broaden users' focus beyond net income. This and other studies suggest that the concern is well founded and that companies are using display format to highlight or obscure results. The current findings confirm that many practitioners favor presenting comprehensive income in the statement of stockholders' equity. There is also significant concern that users will be confused by the growing number of alternative performance measures under the umbrella of comprehensive income.

For comprehensive income reporting to achieve its objectives, the FASB should consider reducing or eliminating the present latitude in display format. A comprehensive review of income reporting should also be undertaken with the goal of assisting readers in identifying appropriate performance measures for various types of decisions. Otherwise, complexity and confusion about the bottom line are likely to increase, limiting the potential of SFAS 130 to assist investors and creditors.

REFERENCES

Campbell, L., D. Crawford and D. Franz (1999). How Companies are Complying with the Comprehensive Income Disclosure Requirements. The Ohio CPA Journal, 58(1), 13-20.

Dhaliwal, D., K. Subramanyam and R. Trezevant (1999). Is Comprehensive Income Superior to Net Income as a Measure of Firm Performance? Journal of Accounting and Economics, 26(1-3), 43-67.

Financial Accounting Standards Board (1985). Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements. Stamford, CT, FASB.

Godwin, N. & C.W. Alderman (1999). Avoiding the Implementation Costs of SFAS No. 130. The CPA Journal, 69(6), 52.

Hirst, D.E. & P. Hopkins (1998). Comprehensive Income Reporting and Analysts' Valuation Judgments. Journal of Accounting Research, 36, 47-75.

Jones, J. & A. Wilson (2000). The Effect of Accounting for Derivatives on Other Comprehensive Income. The CPA Journal, 70(3), 54-56.

Maines, L. & L. McDaniel (2000). Effects of Comprehensive-Income Characteristics on Nonprofessional Investors' Judgments: The Role of Financial-Statement Presentation Format. The Accounting Review, 75(2), 177-204.

R. David Mautz, Jr., North Carolina A&T State University

Ida Robinson-Backmon, University of Baltimore

Table 1: Overall Familiarity with and Assessments of SFAS 130

(means * and standard deviations) Accounting Financial
 Faculty Professionals

Prior to completing this questionnaire, 4.33 3.61
I was very familiar with SFAS 130. * (1.40) (1.84)

Reporting comprehensive income will 3.45 3.07
assist in predicting future cash (1.37) (1.37)
flows. *

Comprehensive income will cause 3.84 3.95
confusion among financial statement (1.66) (1.56)
readers.

SFAS 130 places an unnecessary financial 2.39 3.36
reporting burden on companies. * (1.43) (1.51)

I believe that the FASB should allow per 3.34 3.05
share disclosures of comprehensive (1.53) (1.68)
income.

Asterisk indicates that difference is statistically significant
at < .10.

Costs v. Benefits of SFAS 130

Costs outweigh benefits 17% (10) 41% (10)

Cost and benefits are approximately 30 (18) 32 (31)
equal

Benefits outweigh costs 53 (32) 27 (27)

Total 100% (60) 100% (111)

Missing/no response (4) (13)

Preferred Reporting Format

Single combined statement 49% (29) 26% (27)

Separate statements of income and 39 (23) 43 (46)
comprehensive income

Report in stockholders' equity 12 (7) 31 (33)

Total 100% (59) 100% (106)

Missing/no response (5) (5)

Table 2: Evaluation of Individual Net Income and Comprehensive
Income Items Means and Standard Deviations--Faculty and Financial
Professionals *

 Conveys Relevant to Indicator
 important judgements of mgt
 economic and performance
 information decisions

Net Income 1 2 3

Income from Continuing 5.51 5.43 (0.87) 4.96 (1.10)
Operations (0.84)

Gain or Loss from 4.97 4.52 4.05
Discontinued Operations (1.14) (1.30) (1.36)

Extraordinary Gain or 4.91 4.37 3.53
Loss (1.15) (1.42) (1.45)

Cumulative Effect of an 4.23 3.96 2.97
Accounting Change (1.48) (1.46) (1.46)

Grand Means 4.61/4.45

Comprehensive Income

Foreign Currency 4.35 3.87 3.03
Translation Adjustment (1.31) (1.43) (1.47)

Unrealized Security 4.53 4 3.47
Holding Gain or Loss (1.24) (1.35) (1.50)

Minimum Pension 4.03 3.57 2.96
Liability Adjustment (1.47) (1.54) (1.44)

Comprehensive Income 4.15 3.75 3.51
 (1.55) (1.54) (1.57)

 Should be Should be
 included in reported as
 net income a separate
 line item

Net Income 4 5

Income from Continuing 5.49 5.38
Operations (1.06) (1.05)

Gain or Loss from 4.73 5.26
Discontinued Operations (1.52) (1.11)

Extraordinary Gain or 4.65 5.24
Loss (1.58) (1.13)

Cumulative Effect of an 4.01 4.86
Accounting Change (1.74) (1.47)

Grand Means 4.61/4.45

Comprehensive Income

Foreign Currency 3.50 4.12
Translation Adjustment (1.75) (1.75)

Unrealized Security 3.23 4.04
Holding Gain or Loss (1.79) (1.82)

Minimum Pension 3.12 3.65
Liability Adjustment (1.75) (1.87)

Comprehensive Income 3.29 3.98
 (1.80) (1.85)

 Should be 6-Question
 reported on / 3-
 a per-share Question **
 basis

Net Income 6

Income from Continuing 4.83 5.27/5.30
Operations (1.49)

Gain or Loss from 4.29 4.64/4.51
Discontinued Operations (1.63)

Extraordinary Gain or 4.34 4.51/4.27
Loss (1.66)

Cumulative Effect of an 3.95 4.00/3.72
Accounting Change (1.79)

Grand Means 4.61/4.45

Comprehensive Income

Foreign Currency 2.88 3.63/3.75
Translation Adjustment (1.64)

Unrealized Security 2.72 3.67/4.00
Holding Gain or Loss (1.75)

Minimum Pension 2.47 3.30/3.52
Liability Adjustment (1.59)

Comprehensive Income 3.2 3.65/3.80
 (1.88)

* Scaled responses where 1 = Strongly Disagree and 6 = Strongly Agree
Grand Means 3.56/3.77

** 6-question = average across items 1-6. 3-question = average
across items 1-3.

Table 3: Question-by-Question Ranks of Net Income and Comprehensive
Income Items Faculty and Financial Professionals

Rank Conveys Relevant to Indicator
 important judgements of mgt
 economic and performance
 information decisions

 1 2 3

Net Income

Income from Continuing 1 1 1
Operations

Gain or Loss from 2 2 2

Extraordinary Gain or Loss 3 3 3

Cumulative Effect of an 6 5 7
Accounting Change

Comprehensive Income
Foreign Currency 5 6 6

Translation Adjustment
Unrealized Security 4 4 5

Minimum Pension Liability 8 8 8
Adjustment

Comprehensive Income 7 7 4

Rank Should be Should be Should be
 included in reported reported on
 net income as a a per-share
 separate basis
 line item

 4 5 6

Net Income

Income from Continuing 1 1 1
Operations

Gain or Loss from 2 2 3

Extraordinary Gain or Loss 3 3 2

Cumulative Effect of an 4 4 4
Accounting Change

Comprehensive Income
Foreign Currency 5 5 6

Translation Adjustment
Unrealized Security 7 6 7

Minimum Pension Liability 8 8 8
Adjustment

Comprehensive Income 6 7 5

Table 4: Responses to Open-Ended Questions

 Accounting Financial
 Faculty Professionals

Single Bottom Line
Operating income 0.51 (28) 45% (33)
Net income 18 (10) 37 (27)
Comprehensive income 26 (14) 7 (5)
EPS 5 (3) 7 (5)
Cash flow 4 (3)
Total 100% (64) 100% (111)
Missing/no response (9) (38)
Principal Benefit
Disclosure/detail 34% (18) 33% (22)
Forward view 34 (18) 30 (20)
Understandability 9 (5) 16 (11)
Other 21 (11) 21 (14)
No benefit 2 (1) 0 (0)
Total 100% (53) 100% (67)
Missing/no response (11) (44)
Principal Drawback
Confuse readers 50% (27) 56% (55)
Time/cost to prepare 15 (8) 18 (18)
Added complexity/irrelevance 9 (5) 10 (10)
Other 20 (11) 10 (10)
No drawback 6 (3) 6 (5)
Total 100% (54) 100% (98)
Missing/no response (10) (13)