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    Robert E Jensen
    What is your current viewpoint on the calculation of the...
    question posted June 23, 2011 by Robert E Jensen, last edited March 7, 2012 
    1756 Views, 5 Comments
    question:
    What is your current viewpoint on the calculation of the bottom line?
    details:
    "A New Vision for Accounting:  Robert Herz and FASB are preparing a radical new format for financial, CFO Magazine, by Alix Stuart, February 2008, pp. 49-53 --- http://www.cfo.com/article.cfm/10597001/c_10711055?f=home_todayinfinance

    Last summer, McCormick & Co. controller Ken Kelly sliced and diced his financial statements in ways he had never before imagined. For starters, he split the income statement for the $2.7 billion international spice-and-food company into the three categories of the cash-flow statement: operating, financing, and investing. He extracted discontinued operations and income taxes and placed them in separate categories, instead of peppering them throughout the other results. He created a new form to distinguish which changes in income were due to fair value and which to cash. One traditional ingredient, meanwhile, was conspicuous by its absence: net income.

    Kelly wasn't just indulging a whim. Ahead of a public release of a draft of the Financial Accounting Standards Board's new format for financial statements in the second quarter of 2008, the McCormick controller was trying out the financial statements of the future, a radical departure from current conventions. FASB's so-called financial statement presentation project is ostensibly concerned only with the form, or the "face," of financial statements, but it's quickly becoming clear that it will change and expand their content as well. "This is a complete redefinition of the financial statements as we know them," says John Hepp, a former FASB project manager and now senior manager at Grant Thornton.

    Some of the major changes under discussion: reconfiguring the balance sheet and the income statement to follow the three categories of the cash-flow statement, requiring companies to report cash flows with the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value changes. Companies will also likely have to report more about their segments, possibly down to the same level of detail as they currently report for the consolidated statements. Meanwhile, net income is slated to disappear completely from GAAP financial statements, with no obvious replacement for such commonly used metrics as earnings per share.

    FASB, working with the International Accounting Standards Board (IASB) and accounting standards boards in the United Kingdom and Japan, continues to work out the precise details of the new financial statements. "We are trying to set the stage for what financial statements will look like across the globe for decades to come," says FASB chairman Robert Herz. (Examples of the proposed new financial statements can be viewed at FASB's Website.) If the standard-setters stay their course, CFOs and controllers at every publicly traded company in the world could be following Kelly's lead as soon as 2010.

    It's too early to predict with confidence which changes will ultimately stick. But the mock-up exercise has made Kelly wary. He considers the direct cash-flow statement and reconciliation schedule among the "worst aspects" of the forthcoming proposal, and expects they would require "draconian exercises" from his finance staff, he says. And he questions what would result from the additional details: "If all of a sudden your income statement has 125 lines instead of 25, is that presentation more clarifying, or more confusing?"

    Other financial executives share Kelly's skepticism. In a December CFO survey of more than 200 finance executives, only 17 percent said the changes would offer any benefits to their companies or investors (see "Keep the Bottom Line" at the end of this article). Even some who endorsed the basic aim of the project and like the idea of standardizing categories across the three major financial statements were only cautiously optimistic. "It may be OK, or it may be excessive." says David Rickard, CFO of CVS/Caremark. "The devil will be in the details."

    Net Loss From the outset, corporate financial officers have been ambivalent about FASB's seven year-old project, which was originally launched to address concerns that net income was losing relevance amid a proliferation of pro forma numbers. Back in 2001, Financial Executives International "strongly opposed" it, while executives at Philip Morris, Exxon Mobil, Sears Roebuck, and Microsoft protested to FASB as well.

    (Critics then and now point out that FASB will have little control over pro forma reporting no matter what it does. Indeed, nearly 60 percent of respondents to CFO's survey said they would continue to report pro forma numbers after the new format is introduced.)

    Given the project's starting point, it's not surprising that current drafts of the future income statement omit net income. Right now that's by default, since income taxes are recorded in a separate section. But there is a big push among some board members to make a more fundamental change to eliminate net income by design, and promote business income (income from operations) as the preferred basis for investment metrics.

    "If net income stays, it would be a sign that we failed," says Don Young, a FASB board member. In his mind, the project is not merely about getting rid of net income, but rather about capturing all income-related information in a single line (including such volatile items as gains and losses on cash-flow hedges, available-for-sale securities, and foreign-exchange translations) rather than footnoting them in other comprehensive income (OCI) as they are now. "All changes in net assets and liabilities should be included," says Young. "Why should the income statement be incomplete?" He predicts that the new subtotals, namely business income, will present "a much clearer picture of what's going on."

    Board member Thomas Linsmeier agrees. "The rationale for segregating those items [in OCI] is not necessarily obvious, other than the fact that management doesn't want to be held accountable for them in the current period," he says.

    Whether for self-serving or practical reasons, finance chiefs are rallying behind net income. Nearly 70 percent of those polled by CFO in December said it should stay. "I understand their theories that it's not the be-all and end-all measure that it's put up to be, but it is a measure everyone is familiar with, and sophisticated users can adjust from there," says Kelly. Adds Rickard: "They're treating [net income] as if it's the scourge of the earth, which to me is silly. I think the logical conclusion is to make other things available, rather than hiding the one thing people find most useful."

    . . .

     

    No Bottom Line


    Thank you,

    Bob Jensen

     

    Bob Jensen's threads on this proposed "radical change" in financial reporting are at http://www.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay  

    Comment

     

    • Robert E Jensen

      "EBITDA: WARTS AND ALL," by Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants Blog, March 5, 2012 ---
      http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/542

      With the earnings season upon us, discussions in recent weeks sometimes have focused on pro forma numbers, especially with respect to several IPOs.  Some pro forma numbers are better than others.  Most, however, are inferior to GAAP (generally accepted accounting principles) numbers.

      What these pro forma constructs have in common is that they are non-GAAP numbers, which means that their definition and measurement are not standardized by any agency, and more importantly that corporate disclosures about them are not audited.  By itself, this does not disqualify them from use, but should alert the user to apply caution.

      One particularly good pro forma number is free cash flow.  The variable is supported by economic theory, and its components (cash generated by operating activities and capital expenditures) are found in GAAP financial statements, which means they are audited numbers.

      Continued (with links) in article

      Bob Jensen's threads on pro forma statements ---
      http://www.trinity.edu/rjensen/Theory02.htm#ProForma

      Bob Jensen's threads on earnings management ---
      http://www.trinity.edu/rjensen/Theory02.htm#Manipulation

    • Robert E Jensen

      Question
      If the media insists on reporting one earnings number, which of the alternative earnings numbers should be reported?
      In particular, should net earnings be reported before or after remeasuring financial instruments for unrealized changes in fair value?

      Hint
      The following paper has a great summary of the history of OCI and problems facing the FASB and IASB as we look to the future of financial reporting of business firms.

      "Academic Research and Standard-Setting: The Case of Other Comprehensive Income," by Lynn L. Rees and Philip B. Shane, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 789-815. ---
      http://aaajournals.org/doi/full/10.2308/acch-50237

      This paper links academic accounting research on comprehensive income reporting with the accounting standard-setting efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). We begin by discussing the development of reporting other comprehensive income, and we identify a significant weakness in the FASB's Conceptual Framework, in the lack of a cohesive definition of any subcategory of comprehensive income, including earnings. We identify several attributes that could help allocate comprehensive income between net income, other comprehensive income, and other subcategories. We then review academic research related to remaining standard-setting issues, and identify gaps in academic research where hypotheses could be developed and tested. Our objectives are to (1) stimulate standard-setters to better conceptualize what is meant by other comprehensive income and to distinguish it from earnings, and (2) stimulate researchers to develop and test hypotheses that might help in that process.

      . . .

      Potential Alternative Definitions of Earnings

      Table 1 summarizes and categorizes various standard-setting issues related to reporting comprehensive income, and provides the organizing structure for our literature review later in the paper. The most important of these issues is the definition of earnings, or what makes up earnings and how it is distinguished from OCI. This is a “cross-cutting” issue because it arises when the Boards deliberate on various topics. The Boards cooperatively initiated the financial statement presentation project intending, in part, to solve the comprehensive income composition problem, but the project was subsequently delayed.

      Table 2 presents a list of the specific comprehensive income components under current U.S. GAAP that require recognition as OCI. The second column presents the statement that provided financial reporting guidance for the OCI component, along with its effective date. The effective dates provide an indication as to how the OCI components have expanded over time. Since the issuance of Statement No. 130, which established formal reporting of OCI, new OCI-expanding requirements were promulgated in Statement No. 133. Financial instruments, insurance, and leases are three examples of topics currently on the FASB's agenda where OCI has been discussed as an option to report various gains and losses. In all these discussions, a framework is lacking that can guide standard-setter decisions. The increased use of accumulated OCI to capture various changes in net assets and the likely expansion of OCI items reinforce the notion that standard-setters must eventually come to grips with the distinction between OCI and earnings, or even whether the practice of reporting OCI with recycling should be retained.7

      Presumably, elements with similar informational attributes should be classified together in financial statements. It is unclear what attributes the items listed in Table 2 possess that result in their being characterized differently from other components of income. Notably, the basis for conclusions of the FASB standards gives little to no economic reasoning for the decision to place these items in OCI. While not exhaustive, Table 2 presents four attributes that standard-setters could potentially use to distinguish between earnings and OCI: (1) the degree of persistence of the item, (2) whether the item results from a firm's core operations, (3) whether the item represents a change in net assets that is reasonably within management's control, and (4) whether the item results from remeasurement of an asset/liability. We discuss in turn the merits and potential problems of using these attributes to form a reporting framework for comprehensive income.

      Degree of Persistence.

      The degree of persistence of various comprehensive income components has significant implications for firm value (e.g., Friedman 1957; Kormendi and Lipe 1987; Collins and Kothari 1989). Ohlson's (1995, 1999) valuation model places a heavy emphasis on earnings persistence, which suggests that a reporting format that facilitates identifying the level of persistence across income components could be useful to investors. Examples abound as to how the concept of income persistence has been used in standard-setting, including separate presentation in the income statement for one-time items, extraordinary items, and discontinued operations. Standard-setters have justified several footnote disclosures (segmental disclosures) and disaggregation requirements (e.g., components of pension expense) on the basis of providing information to financial statement users about the persistence of various income statement components.

      Thus, the persistence of revenue and expense items potentially could serve as a distinguishing characteristic of earnings and OCI. Table 2 shows that we regard all the items currently recognized in OCI as having relatively low persistence. However, several other low-persistence items are not recognized in OCI; for example, gains/losses on sale of assets, impairments of assets, restructuring charges, and gains/losses from litigation. To be consistent with this definition of OCI, the current paradigm must change significantly, and the resulting total for OCI would look substantially different from what it is now.

      Using persistence of an item to distinguish earnings from OCI would create significant problems for standard-setters. Persistence can range from completely transitory (zero persistence) to permanent (100 percent persistence). At what point along this range is an item persistent enough to be recorded in earnings? While restructuring charges are typically considered as having low persistence, if they occur every two to three years, is this frequent enough to be classified with other earnings components or infrequent enough to be classified with OCI? Furthermore, the relative persistence of an item likely varies across industries, and even across firms.

      In spite of these inherent difficulties, standard-setters could establish criteria related to persistence that they might use to ultimately determine the classification of particular items. In addition, standard-setters would not be restricted to classifying income components in one of two categories. As an example, highly persistent components could be classified as part of “recurring earnings,” medium-persistence items could go to “other earnings,” and low-persistence items to OCI (or some other nomenclature). Standard-setters could create additional partitions as needed.

      Core Operations.

      Classifying income components as earnings or OCI based on whether they are part of a firm's core operations is intuitively appealing. This criterion is related to income persistence, as we would expect core earnings to be more persistent than noncore income items. Furthermore, classifying income based on whether it is part of core operations has a long history in accounting.

      In current practice, companies and investors place primary importance on some variant of earnings. However, it is not clear which variant of earnings is superior. Many companies report pro forma net income, which presumably provides investors with a more representative measure of the company's core income, but definitions of pro forma earnings vary across firms. Similarly, analysts tend to forecast a company's core earnings (Gu and Chen 2004). Evidence in prior research indicates that pro forma earnings and actual earnings forecasted by analysts are more closely associated with share prices than income from continuing operations based on current U.S. GAAP (e.g., Bradshaw and Sloan 2002; Bhattacharya et al. 2003).

      The problems inherent with this attribute are similar to those of the earnings-persistence criterion. No generally accepted definition of core operations exists. At what point along a continuum does an activity become part of the core operations of a business? As Table 2 indicates, classifying gains/losses from holding available-for-sale securities as part of core earnings depends on whether the firm operates in the financial sector. Different operating environments across firms and industries could make it difficult for standard-setters to determine whether an item belongs in core earnings or OCI.8 In addition, differences in application across firms may give rise to concerns about comparability and potential for abuse on the part of managers in exercising their discretion (e.g., Barth et al. 2011).

      The FASB's (2010) Staff Draft on Financial Statement Presentation tries to address the definitional issue by using interrelationships and synergies between assets and liabilities as a criterion to distinguish operating (or core) activities from investing (or noncore) activities. Specifically, the Staff Draft states:

      An entity shall classify in the operating category:

      Assets that are used as part of the entity's day-to-day business and all changes in those assets Liabilities that arise from the entity's day-to-day business and all changes in those liabilities.

      Operating activities generate revenue through a process that requires the interrelated use of the entity's resources. An asset or a liability that an entity uses to generate a return and any change in that asset or liability shall be classified in the investing category. No significant synergies are created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity. An asset or a liability classified in the investing category may yield a return for the entity in the form of, for example, interest, dividends, royalties, equity income, gains, or losses. (FASB 2010, paras. 72, 73, 81)

      The above distinction between operating activities and investing activities could similarly be used to distinguish between core activities and noncore activities. Alternatively, standard-setters might develop other definitions. Similar to the degree of persistence attribute, standard-setters would not be restricted to a simple core versus noncore dichotomy when using this definition.

      Another possible solution is to allow management to determine which items belong in core earnings. Companies exercise this discretion today when they choose to disclose pro forma earnings. Furthermore, the FASB established the precedent of the “management approach” when it allowed management to determine how to report segment disclosures. In several other areas of U.S. GAAP, management is responsible for establishing boundaries that define its operating environment. FASB Accounting Standards Codification Topic 320 (formerly Statement 115) permits different measurements for identical investments based on management's intent to sell or hold the instrument. Other examples where U.S. GAAP allows for management discretion include determining the rate to discount pension liabilities, defining reporting units, and determining whether an impairment is other than temporary. However, the management approach accentuates the concern about comparability and potential for abuse.

      Management Control.

      Given a premise that evaluating management's stewardship is a primary role of financial statements, a possible rationale for excluding certain items from earnings is that they do not provide a good measure to evaluate management.9 Management can largely control the firm's operating costs and can influence the level of revenues generated. However, some decisions that affect comprehensive income can be established by company policy or the company mission statement and, thus, be outside the control of management. For example, a company policy might be to invest excess cash in marketable securities with the objective of maximizing returns. Once the board of directors establishes this policy, management has little influence over how market-wide fluctuations in security prices affect earnings, and hedging the gains/losses would be inconsistent with the objective of maximizing returns. Similarly, a company's mission statement might include expansion overseas, or prior management might have already decided to establish a foreign subsidiary. The resulting gains/losses from foreign currency fluctuations would seemingly be out of management's control, and hedging these gains/losses would not make economic sense if the subsidiary's functional currency is its local currency and the parent has no intention of repatriating the subsidiary's cash flows.

      Of course, determining what is and is not ostensibly under management's control becomes highly subjective and would probably differ across industries, and perhaps even across firms within industries. For example, gains/losses from investment holdings might not be relevant in evaluating management of some companies, but might be very relevant for managers of holding companies. In addition, the time horizon affects what is under management's control. That is, as the time horizon lengthens, more things are under management's control.

      In Table 2, we classify items as not under management's control if they are based on fluctuations in stock prices or exchange rates, which academic research shows to be largely random within efficient markets. Using this classification model, most, but not all, of the OCI items listed in Table 2 are classified as not under the management's control. Some of the pension items currently recognized in OCI are within the control of management, because management controls the decision to revise a pension plan. While management has control over when to harvest gains/losses on available-for-sale (AFS) securities by deciding when to sell the securities, it cannot control market prices. Thus, under this criterion, unrealized gains/losses on AFS securities are appropriately recognized in OCI. However, gains/losses on trading securities and the effects of tax rate changes are beyond management's control, and yet, these items are currently included as part of earnings. Thus, “management control” does not distinguish what is and is not included in earnings under current U.S. GAAP.

      Remeasurements.

      Barker (2004) explains how the measurement and presentation of comprehensive income might rely on remeasurements. The FASB's (2010) Staff Draft on Financial Statement Presentation defines remeasurements as follows:

      A remeasurement is an amount recognized in comprehensive income that increases or decreases the net carrying amount of an asset or a liability and that is the result of:

      A change in (or realization of) a current price or value A change in an estimate of a current price or value or A change in any estimate or method used to measure the carrying amount of an asset or a liability. (FASB 2010, para. 234)

      Using this definition, examples of remeasurements are impairments of land, unrealized gains/losses due to fair value changes in securities, income tax expenses due to changes in statutory tax rates, and unexpected gains/losses from holding pension assets. All of these items represent a change in carrying value of an already existing asset or liability due to changes in prices or estimates (land, investments, deferred tax asset/liability, and pension asset/liability, respectively).

      Table 3 reproduces a table from Barker (2004) that illustrates how a firm's income statement might look using a “matrix format” if standard-setters adopt the remeasurement approach to reporting comprehensive income. Note that the presentation in Table 3 does not employ earnings as a subtotal of comprehensive income; however, the approach could be modified to define earnings as the sum of all items before remeasurements, if considered useful. Tarca et al. (2008) conduct an experiment with analysts, accountants, and M.B.A. students to assess whether the matrix income statement format in Table 3 facilitates or hinders users' ability to extract information. They find evidence suggesting that the matrix format facilitates more accurate information extraction for users across all sophistication levels relative to a typical format based on IAS 1.

       

      Table 3:  Illustration of Matrix Reporting Format

       

      Employing remeasurements to distinguish between earnings and other comprehensive income largely incorporates the criterion of earnings persistence. Most remeasurements result from price changes, where the current change has little or no association with future changes and, therefore, these components of income are transitory. In contrast, earnings components before remeasurements generally represent items that are likely more persistent.

      Perhaps the most significant advantage of the remeasurement criterion is that it is less subjective than the other criteria previously discussed. Most of the other criteria in Table 2 are continuous in nature. Drawing a bright line to differentiate what belongs in earnings from what belongs in OCI is challenging and will likely be susceptible to income manipulation. In contrast, determining whether a component of income arises from a remeasurement is more straightforward.

      Yet another advantage of this approach is it allows for a full fair value balance sheet that clearly discloses the effects of fair value measurement on periodic comprehensive income, while also showing earnings effects under a modified historical cost system (i.e., before remeasurements). This approach could potentially provide better information about probable future cash flows.

      Other.

      The attributes standard-setters could use to classify income components into earnings or OCI are not limited to the list in Table 2. Ketz (1999) suggests using the level of measurement uncertainty. As an example, gains/losses from Level 1 fair value measurements might be viewed as sufficiently certain to include in earnings, while Level 3 fair value measurements might generate gains/losses that belong in OCI. Song et al. (2010) provide some support for this partition in that they document the value relevance of Level 1 and Level 2 fair values exceeds the value relevance of Level 3 fair values.

      Another potential attribute might be the horizon over which unrealized gains/losses are ultimately realized. That is, unrealized gains/losses from foreign currency fluctuations, term life insurance contracts, or holding pension assets that will not be realized for many years in the future might be disclosed as part of OCI, whereas unrealized gains/losses from trading and available-for-sale securities could be part of earnings.

      As previously discussed, the attributes of measurement uncertainty and timeliness create similar problems in determining where to draw the line. Which items are sufficiently reliable (or timely) to include in earnings, and will differences in implementation across firms and industries impair comparability?

      The overriding purpose of the discussion in this subsection is to point out that several alternative attributes could potentially guide standard-setters in establishing criteria to differentiate earnings from OCI. Ultimately, the choice regarding whether/how to distinguish net income from OCI is a matter of policy. However, academic research can inform policy decisions, as described in the fourth and fifth sections.

      Summary

      Reporting OCI is a relatively recent phenomenon that presumes financial statement users are provided with better information when specific comprehensive income components are excluded from earnings-per-share (EPS), and recycled back into net income only after the occurrence of a specified transaction or event. The number of income components included in OCI has increased over time, and this expansion is likely to continue as standard-setters address new agenda items (e.g., financial instruments and insurance contracts). The lack of a clear definitional distinction between earnings and OCI in the FASB/IASB Conceptual Frameworks has led to: (1) ad hoc decisions on the income components classified in OCI, and (2) no conceptual basis for deciding whether OCI should be excluded from earnings-per-share (EPS) in the current period or recycled through EPS in subsequent periods. In this section, we discussed alternative criteria that standard-setters could use to distinguish earnings from OCI, along with the advantages and challenges of each criterion. Further, due to the inherent difficulties in drawing bright lines between earnings that are persistent versus transitory, core versus noncore, under management control or not, and amenable to remeasurement or not, standard-setters might consider eliminating OCI; that is, they might decide to adopt an all-inclusive income statement approach, where comprehensive income is reporte

      . . .

      Continued in article

      Jensen Comment
      I like this paper. Table 3 could be improved by adding bottom line net earnings before and after remeasurement.

      The paper does not provide all the answers, but it is well written in terms of history up to this point in time and alternative directions for consideration.

    • Robert E Jensen

      OCI Reporting Update From Ernst & Young on February 28, 2013

      Technical Line: What the new AOCI disclosures will look like

      The FASB has issued new guidance requiring companies to report, in one place, information about reclassifications out of accumulated other comprehensive income (AOCI). Companies are also required to present reclassifications by component when reporting changes in AOCI balances. Public companies must make the disclosures in fiscal years and interim periods within those years beginning after 15 December 2012. For calendar-year public companies, that means the first quarter of 2013. For nonpublic companies, the Accounting Standards Update (ASU) is effective for fiscal years beginning after 15 December 2013 and interim and annual periods thereafter. The guidance should be applied prospectively. Our Technical Line publication describes the requirements and provides examples of what the disclosures might look like.

      Download --- Click Here
      http://www.ey.com/publication/vwluassetsdld/technicalline_bb2503_aoci_27february2013/$file/technicalline_bb2503_aoci_27february2013.pdf?OpenElement

      "Academic Research and Standard-Setting: The Case of Other Comprehensive Income," by Lynn L. Rees and Philip B. Shane, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 789-815. ---
      http://aaajournals.org/doi/full/10.2308/acch-50237

      This paper links academic accounting research on comprehensive income reporting with the accounting standard-setting efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). We begin by discussing the development of reporting other comprehensive income, and we identify a significant weakness in the FASB's Conceptual Framework, in the lack of a cohesive definition of any subcategory of comprehensive income, including earnings. We identify several attributes that could help allocate comprehensive income between net income, other comprehensive income, and other subcategories. We then review academic research related to remaining standard-setting issues, and identify gaps in academic research where hypotheses could be developed and tested. Our objectives are to (1) stimulate standard-setters to better conceptualize what is meant by other comprehensive income and to distinguish it from earnings, and (2) stimulate researchers to develop and test hypotheses that might help in that process.

      . . .

      Potential Alternative Definitions of Earnings

      Table 1 summarizes and categorizes various standard-setting issues related to reporting comprehensive income, and provides the organizing structure for our literature review later in the paper. The most important of these issues is the definition of earnings, or what makes up earnings and how it is distinguished from OCI. This is a “cross-cutting” issue because it arises when the Boards deliberate on various topics. The Boards cooperatively initiated the financial statement presentation project intending, in part, to solve the comprehensive income composition problem, but the project was subsequently delayed.

      Table 2 presents a list of the specific comprehensive income components under current U.S. GAAP that require recognition as OCI. The second column presents the statement that provided financial reporting guidance for the OCI component, along with its effective date. The effective dates provide an indication as to how the OCI components have expanded over time. Since the issuance of Statement No. 130, which established formal reporting of OCI, new OCI-expanding requirements were promulgated in Statement No. 133. Financial instruments, insurance, and leases are three examples of topics currently on the FASB's agenda where OCI has been discussed as an option to report various gains and losses. In all these discussions, a framework is lacking that can guide standard-setter decisions. The increased use of accumulated OCI to capture various changes in net assets and the likely expansion of OCI items reinforce the notion that standard-setters must eventually come to grips with the distinction between OCI and earnings, or even whether the practice of reporting OCI with recycling should be retained.7

      Presumably, elements with similar informational attributes should be classified together in financial statements. It is unclear what attributes the items listed in Table 2 possess that result in their being characterized differently from other components of income. Notably, the basis for conclusions of the FASB standards gives little to no economic reasoning for the decision to place these items in OCI. While not exhaustive, Table 2 presents four attributes that standard-setters could potentially use to distinguish between earnings and OCI: (1) the degree of persistence of the item, (2) whether the item results from a firm's core operations, (3) whether the item represents a change in net assets that is reasonably within management's control, and (4) whether the item results from remeasurement of an asset/liability. We discuss in turn the merits and potential problems of using these attributes to form a reporting framework for comprehensive income.

      Degree of Persistence.

      The degree of persistence of various comprehensive income components has significant implications for firm value (e.g., Friedman 1957; Kormendi and Lipe 1987; Collins and Kothari 1989). Ohlson's (1995, 1999) valuation model places a heavy emphasis on earnings persistence, which suggests that a reporting format that facilitates identifying the level of persistence across income components could be useful to investors. Examples abound as to how the concept of income persistence has been used in standard-setting, including separate presentation in the income statement for one-time items, extraordinary items, and discontinued operations. Standard-setters have justified several footnote disclosures (segmental disclosures) and disaggregation requirements (e.g., components of pension expense) on the basis of providing information to financial statement users about the persistence of various income statement components.

      Thus, the persistence of revenue and expense items potentially could serve as a distinguishing characteristic of earnings and OCI. Table 2 shows that we regard all the items currently recognized in OCI as having relatively low persistence. However, several other low-persistence items are not recognized in OCI; for example, gains/losses on sale of assets, impairments of assets, restructuring charges, and gains/losses from litigation. To be consistent with this definition of OCI, the current paradigm must change significantly, and the resulting total for OCI would look substantially different from what it is now.

      Using persistence of an item to distinguish earnings from OCI would create significant problems for standard-setters. Persistence can range from completely transitory (zero persistence) to permanent (100 percent persistence). At what point along this range is an item persistent enough to be recorded in earnings? While restructuring charges are typically considered as having low persistence, if they occur every two to three years, is this frequent enough to be classified with other earnings components or infrequent enough to be classified with OCI? Furthermore, the relative persistence of an item likely varies across industries, and even across firms.

      In spite of these inherent difficulties, standard-setters could establish criteria related to persistence that they might use to ultimately determine the classification of particular items. In addition, standard-setters would not be restricted to classifying income components in one of two categories. As an example, highly persistent components could be classified as part of “recurring earnings,” medium-persistence items could go to “other earnings,” and low-persistence items to OCI (or some other nomenclature). Standard-setters could create additional partitions as needed.

      Core Operations.

      Classifying income components as earnings or OCI based on whether they are part of a firm's core operations is intuitively appealing. This criterion is related to income persistence, as we would expect core earnings to be more persistent than noncore income items. Furthermore, classifying income based on whether it is part of core operations has a long history in accounting.

      In current practice, companies and investors place primary importance on some variant of earnings. However, it is not clear which variant of earnings is superior. Many companies report pro forma net income, which presumably provides investors with a more representative measure of the company's core income, but definitions of pro forma earnings vary across firms. Similarly, analysts tend to forecast a company's core earnings (Gu and Chen 2004). Evidence in prior research indicates that pro forma earnings and actual earnings forecasted by analysts are more closely associated with share prices than income from continuing operations based on current U.S. GAAP (e.g., Bradshaw and Sloan 2002; Bhattacharya et al. 2003).

      The problems inherent with this attribute are similar to those of the earnings-persistence criterion. No generally accepted definition of core operations exists. At what point along a continuum does an activity become part of the core operations of a business? As Table 2 indicates, classifying gains/losses from holding available-for-sale securities as part of core earnings depends on whether the firm operates in the financial sector. Different operating environments across firms and industries could make it difficult for standard-setters to determine whether an item belongs in core earnings or OCI.8 In addition, differences in application across firms may give rise to concerns about comparability and potential for abuse on the part of managers in exercising their discretion (e.g., Barth et al. 2011).

      The FASB's (2010) Staff Draft on Financial Statement Presentation tries to address the definitional issue by using interrelationships and synergies between assets and liabilities as a criterion to distinguish operating (or core) activities from investing (or noncore) activities. Specifically, the Staff Draft states:

      An entity shall classify in the operating category:

      Assets that are used as part of the entity's day-to-day business and all changes in those assets Liabilities that arise from the entity's day-to-day business and all changes in those liabilities.

      Operating activities generate revenue through a process that requires the interrelated use of the entity's resources. An asset or a liability that an entity uses to generate a return and any change in that asset or liability shall be classified in the investing category. No significant synergies are created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity. An asset or a liability classified in the investing category may yield a return for the entity in the form of, for example, interest, dividends, royalties, equity income, gains, or losses. (FASB 2010, paras. 72, 73, 81)

      The above distinction between operating activities and investing activities could similarly be used to distinguish between core activities and noncore activities. Alternatively, standard-setters might develop other definitions. Similar to the degree of persistence attribute, standard-setters would not be restricted to a simple core versus noncore dichotomy when using this definition.

      Another possible solution is to allow management to determine which items belong in core earnings. Companies exercise this discretion today when they choose to disclose pro forma earnings. Furthermore, the FASB established the precedent of the “management approach” when it allowed management to determine how to report segment disclosures. In several other areas of U.S. GAAP, management is responsible for establishing boundaries that define its operating environment. FASB Accounting Standards Codification Topic 320 (formerly Statement 115) permits different measurements for identical investments based on management's intent to sell or hold the instrument. Other examples where U.S. GAAP allows for management discretion include determining the rate to discount pension liabilities, defining reporting units, and determining whether an impairment is other than temporary. However, the management approach accentuates the concern about comparability and potential for abuse.

      Management Control.

      Given a premise that evaluating management's stewardship is a primary role of financial statements, a possible rationale for excluding certain items from earnings is that they do not provide a good measure to evaluate management.9 Management can largely control the firm's operating costs and can influence the level of revenues generated. However, some decisions that affect comprehensive income can be established by company policy or the company mission statement and, thus, be outside the control of management. For example, a company policy might be to invest excess cash in marketable securities with the objective of maximizing returns. Once the board of directors establishes this policy, management has little influence over how market-wide fluctuations in security prices affect earnings, and hedging the gains/losses would be inconsistent with the objective of maximizing returns. Similarly, a company's mission statement might include expansion overseas, or prior management might have already decided to establish a foreign subsidiary. The resulting gains/losses from foreign currency fluctuations would seemingly be out of management's control, and hedging these gains/losses would not make economic sense if the subsidiary's functional currency is its local currency and the parent has no intention of repatriating the subsidiary's cash flows.

      Of course, determining what is and is not ostensibly under management's control becomes highly subjective and would probably differ across industries, and perhaps even across firms within industries. For example, gains/losses from investment holdings might not be relevant in evaluating management of some companies, but might be very relevant for managers of holding companies. In addition, the time horizon affects what is under management's control. That is, as the time horizon lengthens, more things are under management's control.

      In Table 2, we classify items as not under management's control if they are based on fluctuations in stock prices or exchange rates, which academic research shows to be largely random within efficient markets. Using this classification model, most, but not all, of the OCI items listed in Table 2 are classified as not under the management's control. Some of the pension items currently recognized in OCI are within the control of management, because management controls the decision to revise a pension plan. While management has control over when to harvest gains/losses on available-for-sale (AFS) securities by deciding when to sell the securities, it cannot control market prices. Thus, under this criterion, unrealized gains/losses on AFS securities are appropriately recognized in OCI. However, gains/losses on trading securities and the effects of tax rate changes are beyond management's control, and yet, these items are currently included as part of earnings. Thus, “management control” does not distinguish what is and is not included in earnings under current U.S. GAAP.

      Remeasurements.

      Barker (2004) explains how the measurement and presentation of comprehensive income might rely on remeasurements. The FASB's (2010) Staff Draft on Financial Statement Presentation defines remeasurements as follows:

      A remeasurement is an amount recognized in comprehensive income that increases or decreases the net carrying amount of an asset or a liability and that is the result of:

      A change in (or realization of) a current price or value A change in an estimate of a current price or value or A change in any estimate or method used to measure the carrying amount of an asset or a liability. (FASB 2010, para. 234)

      Using this definition, examples of remeasurements are impairments of land, unrealized gains/losses due to fair value changes in securities, income tax expenses due to changes in statutory tax rates, and unexpected gains/losses from holding pension assets. All of these items represent a change in carrying value of an already existing asset or liability due to changes in prices or estimates (land, investments, deferred tax asset/liability, and pension asset/liability, respectively).

      Table 3 reproduces a table from Barker (2004) that illustrates how a firm's income statement might look using a “matrix format” if standard-setters adopt the remeasurement approach to reporting comprehensive income. Note that the presentation in Table 3 does not employ earnings as a subtotal of comprehensive income; however, the approach could be modified to define earnings as the sum of all items before remeasurements, if considered useful. Tarca et al. (2008) conduct an experiment with analysts, accountants, and M.B.A. students to assess whether the matrix income statement format in Table 3 facilitates or hinders users' ability to extract information. They find evidence suggesting that the matrix format facilitates more accurate information extraction for users across all sophistication levels relative to a typical format based on IAS 1.

       

      Table 3:  Illustration of Matrix Reporting Format
      http://www.cs.trinity.edu/~rjensen/temp/ReesShane2012Table3.jpg

       

      Employing remeasurements to distinguish between earnings and other comprehensive income largely incorporates the criterion of earnings persistence. Most remeasurements result from price changes, where the current change has little or no association with future changes and, therefore, these components of income are transitory. In contrast, earnings components before remeasurements generally represent items that are likely more persistent.

      Perhaps the most significant advantage of the remeasurement criterion is that it is less subjective than the other criteria previously discussed. Most of the other criteria in Table 2 are continuous in nature. Drawing a bright line to differentiate what belongs in earnings from what belongs in OCI is challenging and will likely be susceptible to income manipulation. In contrast, determining whether a component of income arises from a remeasurement is more straightforward.

      Yet another advantage of this approach is it allows for a full fair value balance sheet that clearly discloses the effects of fair value measurement on periodic comprehensive income, while also showing earnings effects under a modified historical cost system (i.e., before remeasurements). This approach could potentially provide better information about probable future cash flows.

      Other.

      The attributes standard-setters could use to classify income components into earnings or OCI are not limited to the list in Table 2. Ketz (1999) suggests using the level of measurement uncertainty. As an example, gains/losses from Level 1 fair value measurements might be viewed as sufficiently certain to include in earnings, while Level 3 fair value measurements might generate gains/losses that belong in OCI. Song et al. (2010) provide some support for this partition in that they document the value relevance of Level 1 and Level 2 fair values exceeds the value relevance of Level 3 fair values.

      Another potential attribute might be the horizon over which unrealized gains/losses are ultimately realized. That is, unrealized gains/losses from foreign currency fluctuations, term life insurance contracts, or holding pension assets that will not be realized for many years in the future might be disclosed as part of OCI, whereas unrealized gains/losses from trading and available-for-sale securities could be part of earnings.

      As previously discussed, the attributes of measurement uncertainty and timeliness create similar problems in determining where to draw the line. Which items are sufficiently reliable (or timely) to include in earnings, and will differences in implementation across firms and industries impair comparability?

      The overriding purpose of the discussion in this subsection is to point out that several alternative attributes could potentially guide standard-setters in establishing criteria to differentiate earnings from OCI. Ultimately, the choice regarding whether/how to distinguish net income from OCI is a matter of policy. However, academic research can inform policy decisions, as described in the fourth and fifth sections.

      Summary

      Reporting OCI is a relatively recent phenomenon that presumes financial statement users are provided with better information when specific comprehensive income components are excluded from earnings-per-share (EPS), and recycled back into net income only after the occurrence of a specified transaction or event. The number of income components included in OCI has increased over time, and this expansion is likely to continue as standard-setters address new agenda items (e.g., financial instruments and insurance contracts). The lack of a clear definitional distinction between earnings and OCI in the FASB/IASB Conceptual Frameworks has led to: (1) ad hoc decisions on the income components classified in OCI, and (2) no conceptual basis for deciding whether OCI should be excluded from earnings-per-share (EPS) in the current period or recycled through EPS in subsequent periods. In this section, we discussed alternative criteria that standard-setters could use to distinguish earnings from OCI, along with the advantages and challenges of each criterion. Further, due to the inherent difficulties in drawing bright lines between earnings that are persistent versus transitory, core versus noncore, under management control or not, and amenable to remeasurement or not, standard-setters might consider eliminating OCI; that is, they might decide to adopt an all-inclusive income statement approach, where comprehensive income is reporte

      . . .

      Continued in article

       

    • Robert E Jensen

      Teaching Case on How More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
      From The Wall Street Journal Accounting Weekly Review on March 7, 2014

      Some Firms Alter the Bonus Playbook
      by: Michael Rapoport
      Feb 27, 2014
      Click here to view the full article on WSJ.com
      Click here to view the video on WSJ.com WSJ Video
       

      TOPICS: Corporate Governance, Executive Compensation, Financial Accounting, GAAP, Goodwill

      SUMMARY: From 2009 to 2013, the number of companies using non-GAAP financial measures to determine compensation grew from 249 to 542, 28% of the 1,957 firms with at least $700 million of stock held outside the company's control. In the related video, author Michael Rapoport focuses on McKesson Corp. The company reports non-GAAP metrics in announcements to shareholders and then further adjusts earnings measures for determining executive bonuses. "Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures."

      CLASSROOM APPLICATION: The article and related video provide an excellent discussion for use in financial accounting classes covering non-GAAP earnings, executive compensation, and or goodwill accounting.

      QUESTIONS: 
      1. (Introductory) What is corporate governance?

      2. (Advanced) Last year, McKesson's shareholders voted against the company's executive compensation pay package. Why then is the company still using this package? How does that situation reflect on the company's corporate governance?

      3. (Introductory) What is incentive compensation?

      4. (Advanced) Focus on the paragraphs about Trex Co. How did the company adjust its determination of income used as the basis for CEO Ronald W. Kaplan's incentive compensation? What was the reasoning for this treatment? Do you agree with this approach?

      5. (Introductory) What is a goodwill write down?

      6. (Advanced) Consider the Boston Scientific Corp. exclusion of goodwill writedowns from determining its CEO's incentive compensation. How might this adjustment set an improper incentive for the CEO?
       

      Reviewed By: Judy Beckman, University of Rhode Island

      "Some Firms Alter the Bonus Playbook," by Michael Rapoport, The Wall Street Journal, March 27, 2014 ---
      http://online.wsj.com/news/articles/SB10001424052702304834704579405411156046356?mod=djem_jiewr_AC_domainid

      More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
      Graphs not quoted here

      U.S. companies increasingly are using unconventional earnings measures in determining bonuses, making it easier for them to appear more profitable when they reward executives with big paydays.

      Last year, 542 companies said they determine compensation using financial measurements that differ from U.S. accounting standards, according to an analysis performed by consultant Audit Analytics for The Wall Street Journal. That is more than double the 249 companies that did so in 2009. The practice can be controversial because it strips out various costs—from employee stock payments to asset write-downs—that can depress profits.

      Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures. The commission declined to comment on their use in executive-pay decisions.

      "Everything you can think of to manipulate this has been done," said Gary Hewitt, head of research at GMI Ratings, a corporate-governance research firm.

      U.S. companies report quarterly results based on generally accepted accounting principles, or GAAP, but regulators also allow them to provide non-GAAP adjusted measures as long as they provide proper disclosure. Some companies use the non-GAAP measures as the basis for the profit targets they must hit to award incentive bonuses to executives.

      Companies are allowed to use nonstandard measures in setting executive pay, and some observers said they better represent a company's health and its executives' performances by excluding items the companies don't see as relevant to their core operations. Others disagree.

      "We're very frustrated with that," said Michael Pryce-Jones, a senior governance analyst at CtW Investment Group, which works with union pension funds on shareholder initiatives. When companies use such customized measures, he said, investors "are being given the upside, but they're not being given the downside."

      For its analysis, Audit Analytics examined public firms with $700 million or more in stock not under the company's control. The results showed the use of nonstandard measures for executive pay has risen steadily each year since 2009. The 542 companies represent 28% of the 1,957 firms examined by Audit Analytics for 2013.

      One example cited by some corporate-governance advocates: medical-products distributor McKesson Corp. MCK +0.34% , which awarded Chief Executive John Hammergren $51.7 million in compensation for fiscal 2013.

      To help determine the $3.7 million he received in short-term incentive pay, McKesson used a measure of its earnings it adjusted not once but twice. It took the nonstandard earnings measures it disclosed to investors in its earnings reports, which already had stripped out a variety of expenses, to boost the year's earnings by 74 cents a share, to $6.33, and then stripped out more costs to increase earnings an additional 88 cents, to $7.21.

      Activist shareholders have complained about McKesson's pay structure, including its use of handpicked metrics. Shareholders voted "no" by more than a 3-to-1 margin last year on a nonbinding resolution to approve the company's executive-compensation package.

      "This is something we're absolutely focusing on, looking at adjustments being made in bonus plans," said Mr. Pryce-Jones of CtW Investment Group, which was active in the campaign against McKesson.

      McKesson said its board "exercises great discipline" in deciding on pay, and its modifications are representative of its recurring performance and match how Wall Street views its profits.

      Some others think the non-GAAP use is justified. "I really don't see the sort of blatant attempt to jigger the numbers so that someone gets more compensation than they're entitled to," said Charles Vaughn, a lawyer at Nelson Mullins Riley & Scarborough LLP in Atlanta who advises boards on compensation.

      But other observers think some companies exclude some expenses from nonstandard measures that really shouldn't be excluded, like stock compensation, which they contend is a legitimate cost.

      Continued in article

      Bob Jensen's threads on pro forma earnings before all the bad stuff ---
      http://www.trinity.edu/rjensen/Theory02.htm#ProForma

    • Robert E Jensen

      Teaching Case on How More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
      From The Wall Street Journal Accounting Weekly Review on March 7, 2014

      Some Firms Alter the Bonus Playbook
      by: Michael Rapoport
      Feb 27, 2014
      Click here to view the full article on WSJ.com
      Click here to view the video on WSJ.com WSJ Video
       

      TOPICS: Corporate Governance, Executive Compensation, Financial Accounting, GAAP, Goodwill

      SUMMARY: From 2009 to 2013, the number of companies using non-GAAP financial measures to determine compensation grew from 249 to 542, 28% of the 1,957 firms with at least $700 million of stock held outside the company's control. In the related video, author Michael Rapoport focuses on McKesson Corp. The company reports non-GAAP metrics in announcements to shareholders and then further adjusts earnings measures for determining executive bonuses. "Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures."

      CLASSROOM APPLICATION: The article and related video provide an excellent discussion for use in financial accounting classes covering non-GAAP earnings, executive compensation, and or goodwill accounting.

      QUESTIONS: 
      1. (Introductory) What is corporate governance?

      2. (Advanced) Last year, McKesson's shareholders voted against the company's executive compensation pay package. Why then is the company still using this package? How does that situation reflect on the company's corporate governance?

      3. (Introductory) What is incentive compensation?

      4. (Advanced) Focus on the paragraphs about Trex Co. How did the company adjust its determination of income used as the basis for CEO Ronald W. Kaplan's incentive compensation? What was the reasoning for this treatment? Do you agree with this approach?

      5. (Introductory) What is a goodwill write down?

      6. (Advanced) Consider the Boston Scientific Corp. exclusion of goodwill writedowns from determining its CEO's incentive compensation. How might this adjustment set an improper incentive for the CEO?
       

      Reviewed By: Judy Beckman, University of Rhode Island

      "Some Firms Alter the Bonus Playbook," by Michael Rapoport, The Wall Street Journal, March 27, 2014 ---
      http://online.wsj.com/news/articles/SB10001424052702304834704579405411156046356?mod=djem_jiewr_AC_domainid

      More U.S. Firms Use Nonstandard Accounting Measures to Figure Executive Payouts
      Graphs not quoted here

      U.S. companies increasingly are using unconventional earnings measures in determining bonuses, making it easier for them to appear more profitable when they reward executives with big paydays.

      Last year, 542 companies said they determine compensation using financial measurements that differ from U.S. accounting standards, according to an analysis performed by consultant Audit Analytics for The Wall Street Journal. That is more than double the 249 companies that did so in 2009. The practice can be controversial because it strips out various costs—from employee stock payments to asset write-downs—that can depress profits.

      Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures. The commission declined to comment on their use in executive-pay decisions.

      "Everything you can think of to manipulate this has been done," said Gary Hewitt, head of research at GMI Ratings, a corporate-governance research firm.

      U.S. companies report quarterly results based on generally accepted accounting principles, or GAAP, but regulators also allow them to provide non-GAAP adjusted measures as long as they provide proper disclosure. Some companies use the non-GAAP measures as the basis for the profit targets they must hit to award incentive bonuses to executives.

      Companies are allowed to use nonstandard measures in setting executive pay, and some observers said they better represent a company's health and its executives' performances by excluding items the companies don't see as relevant to their core operations. Others disagree.

      "We're very frustrated with that," said Michael Pryce-Jones, a senior governance analyst at CtW Investment Group, which works with union pension funds on shareholder initiatives. When companies use such customized measures, he said, investors "are being given the upside, but they're not being given the downside."

      For its analysis, Audit Analytics examined public firms with $700 million or more in stock not under the company's control. The results showed the use of nonstandard measures for executive pay has risen steadily each year since 2009. The 542 companies represent 28% of the 1,957 firms examined by Audit Analytics for 2013.

      One example cited by some corporate-governance advocates: medical-products distributor McKesson Corp. MCK +0.34% , which awarded Chief Executive John Hammergren $51.7 million in compensation for fiscal 2013.

      To help determine the $3.7 million he received in short-term incentive pay, McKesson used a measure of its earnings it adjusted not once but twice. It took the nonstandard earnings measures it disclosed to investors in its earnings reports, which already had stripped out a variety of expenses, to boost the year's earnings by 74 cents a share, to $6.33, and then stripped out more costs to increase earnings an additional 88 cents, to $7.21.

      Activist shareholders have complained about McKesson's pay structure, including its use of handpicked metrics. Shareholders voted "no" by more than a 3-to-1 margin last year on a nonbinding resolution to approve the company's executive-compensation package.

      "This is something we're absolutely focusing on, looking at adjustments being made in bonus plans," said Mr. Pryce-Jones of CtW Investment Group, which was active in the campaign against McKesson.

      McKesson said its board "exercises great discipline" in deciding on pay, and its modifications are representative of its recurring performance and match how Wall Street views its profits.

      Some others think the non-GAAP use is justified. "I really don't see the sort of blatant attempt to jigger the numbers so that someone gets more compensation than they're entitled to," said Charles Vaughn, a lawyer at Nelson Mullins Riley & Scarborough LLP in Atlanta who advises boards on compensation.

      But other observers think some companies exclude some expenses from nonstandard measures that really shouldn't be excluded, like stock compensation, which they contend is a legitimate cost.

      Continued in article

      Bob Jensen's threads on pro forma earnings before all the bad stuff ---
      http://www.trinity.edu/rjensen/Theory02.htm#ProForma