P2 Concepts of profit or loss and other comprehensive income（1）

he performance of a company is reported in the statement of profit or loss and other comprehensive income. IAS 1, Presentation of Financial Statements, defines profit or loss as ‘the total of income less expenses, excluding the components of other comprehensive income’. Other comprehensive income (OCI) is defined as comprising ‘items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other IFRSs’. Total comprehensive income is defined as ‘the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners’.

It is a myth, and simply incorrect, to state that only realised gains are included in profit or loss (P/L) and that only unrealised gains and losses are included in the OCI. For example, gains on the revaluation of land and buildings accounted for in accordance with IAS 16, Property Plant and Equipment (IAS 16 PPE), are recognised in OCI and accumulate in equity in Other Components of Equity (OCE). On the other hand, gains on the revaluation of land and buildings accounted for in accordance with IAS 40, Investment Properties, are recognised in P/L and are part of the Retained Earnings (RE). Both such gains are unrealised. The same point could be made with regard to the gains and losses on the financial asset of equity investments. If such financial assets are designated in accordance with IFRS 9, Financial Instruments (IFRS 9), at inception as Fair Value Through Other Comprehensive Income (FVTOCI) then the gains and losses are recognised in OCI and accumulated in equity in OCE. Whereas if management decides not to make this election, then the investment will by default be designated and accounted for as Fair Value Through Profit or Loss (FVTP&L) and the gains and losses are recognised in P/L and become part of RE.

There is at present no overarching accounting theory that justifies or explains in which part of the statement gains and losses should be reported. The IASB’s Conceptual Framework for Financial Reporting is silent on the matter. So rather than have a clear principles based approach what we currently have is a rules based approach to this issue. It is down to individual accounting standards to direct when gains and losses are to be reported in OCI. This is clearly an unsatisfactory approach. It is confusing for users.

In July 2013 the International Accounting Standards Board (IASB) published a discussion paper on its Conceptual Framework for Financial Reporting. This addressed the issue of where to recognise gains and losses. It suggests that the P/L should provide the primary source of information about the return an entity has made on its economic resources in a period. Accordingly the P/L should recognise the results of transactions, consumption and impairments of assets and fulfilment of liabilities in the period in which they occur. In addition the P/L would also recognise changes in the cost of assets and liabilities as well as any gains or losses resulting from their initial recognition. The role of the OCI would then be to support the P/L. Gains and losses would only be recognised in OCI if it made the P&L more relevant. In my view whilst this may be an improvement on the current absence of any guidance it does not provide the clarity and certainty users crave.

Recycling (the reclassification from equity to P&L)

Now let us consider the issue of recycling. This is where gains or losses are reclassified from equity to P/L as a reclassification adjustment. In other words gains or losses are first recognised in the OCI and then in a later accounting period also recognised in the P/L. In this way the gain or loss is reported in the total comprehensive income of two accounting periods and in colloquial terms is said to be recycled as it is recognised twice. At present it is down to individual accounting standards to direct when gains and losses are to be reclassified from equity to P/L as a reclassification adjustment. So rather than have a clear principles based approach on recycling what we currently have is a rules based approach to this issue. This is clearly, again, an unsatisfactory approach but also as we shall see one addressed by the July 2013 IASB discussion paper on its Conceptual Framework for Financial Reporting

IAS 21, The Effects of Changes in Foreign Exchange Rates (IAS 21), is one example of a standard that requires gains and losses to be reclassified from equity to P/L as a reclassification adjustment. When a group has an overseas subsidiary a group exchange difference will arise on the re-translation of the subsidiary’s goodwill and net assets. In accordance with IAS 21 such exchange differences are recognised in OCI and so accumulate in OCE. On the disposal of the subsidiary, IAS 21 requires that the net cumulative balance of group exchange differences be reclassified from equity to P&L as a reclassification adjustment – ie the balance of the group exchange differences in OCE is transferred to P/L to form part of the profit on disposal.

IAS 16 PPE is one example of a standard that prohibits gains and losses to be reclassified from equity to P/L as a reclassification adjustment. If we consider land that cost $10m which is treated in accordance with IAS 16 PPE. If the land is subsequently revalued to $12m, then the gain of $2m is recognised in OCI and will be taken to OCE. When in a later period the asset is sold for $13m, IAS 16 PPE specifically requires that the profit on disposal recognised in the P/L is $1m – ie the difference between the sale proceeds of $13m and the carrying value of $12m. The previously recognised gain of $2m is not recycled/reclassified back to P/L as part of the gain on disposal. However the $2m balance in the OCE reserve is now redundant as the asset has been sold and the profit is realised. Accordingly, there will be a transfer in the Statement of Changes in Equity, from the OCE of $2m into RE.

Double entry

For those who love the double entry let me show you the purchase, the revaluation, the disposal and the transfer to RE in this way.