21 Jul 2014
Anyone who’s tuned into the standard setting process for, say, insurance contracts, knows that these things can run a little over time. The exposure draft for the International Accounting Standards Board’s Conceptual Framework for Financial Reporting is due relatively soon (Q4 2014), but there are some tricky parts of the proposals that could end up slowing things down. Especially since, in a recent speech, IASB head Hans Hoogervorst highlighted that the responses to the discussion paper laying out the possible plans for the conceptual framework had been many, varied and in some cases, vociferous.
According to Mr Hoogervorst, one of the most hotly debated issues has been ‘other comprehensive income’ (OCI) and its big brother, ‘profit or loss’.
If all goes well, the IASB will use their conceptual framework to describe what the purpose of OCI is; what should be reported under it and what should go into profit or loss and what, if anything, can be ‘recycled’ – i.e., items that are recognised in OCI and then again in profit or loss when the underlying item is sold or realised.
All of this thinking will be very important. Right now, there is no obvious principle that drives gains and losses out of profit or loss and into OCI. Items that pop up in OCI all reflect re-measurement as a result of movements in price or valuation. But at the moment, there is no shared view among the IASB’s constituents about what should be in profit or loss and what should be in OCI.
What goes into OCI is partly defined by what goes into profit or loss. And the IASB is keen that the latter is the ‘primary source of information about the return an entity has made on its economic resources in a period’. Put simply, profit or loss is the most widely used measure by both sophisticated and unsophisticated investors and is the “primary indicator of performance”.
But the IASB says that defining profit or loss is easier said than done – so you can’t define OCI by the back door. The closest anyone has come, they say, is the Japanese accounting standards board who defined it as “an all-inclusive measure of irreversible outcomes of an entity’s business activities in a certain period”. It’s something of a mouthful, but Mr Hoogervorst described it as “courageous” and “neat”.
Some of the responses to the IASB’s discussion paper said that the Board shouldn’t even try to deal with defining OCI on a conceptual level, because a sound conclusion is unlikely to be reached. But the IASB believes that we are in “urgent need” of guidance, giving the example of American car manufacturers that were “brought to their knees by employee benefits that had been building up over the years” and had been presented in OCI. I’d agree with their sentiment that “unrealised does not mean unreal”.
So what do I think? I agree with the IASB that profit or loss is extremely important and should be as broad as possible. As the Board comes up with its approach to OCI for the exposure draft, it should give high priority to net income – because even though investors look to a wide range of performance measures, net income is most common starting point.
Some have suggested more lateral approaches, like getting rid of subtotals like net income and disaggregating all results. But I am not sure the broader investor community is ready for that. Not all investors are sophisticated and able calculate their own measures to tell them about performance.
Others are also saying that the effects of all market changes should be excluded from profit or loss and put into OCI. They say that these impacts are outside of management’s control and can introduce volatility. I disagree. Management makes all business and investment decisions for a company and often enters markets to generate cashflows on anticipated market movements. Excluding the effects of market changes from profit or loss would be masking elements of the entity’s performance.
So, as the IASB says, OCI should be used sparingly. A narrow subset of information should be eligible for exclusion from net income – only measurements that do not reflect current performance should be left out.
Then, items outside of profit or loss need to be recycled back in, when the reason for initial inclusion in OCI no longer applies. Recycling is important, again, because investors rely on net income for their performance analyses.
Exactly when an item is recycled is something that needs to be decided by the IASB – and they need to consult investors on that. If we accept net income as the primary measure of performance, permanently excluding items from it should not be an option.
And what if a single principle for recycling is out of reach, as it may well be, come Q4? The Board needs to acknowledge that investors are best served by minimising items excluded from net income and then develop criteria to identify the exceptions. Once those are identified, everyone can work towards a consensus about when to realise such items in net income.
In summary, profit or loss should be protected and on the understanding that it needs to be as inclusive as humanly possible, we should all accept that it won’t be as svelte as we might desire. OCI needs to be, as the IASB has said, “an instrument of last resort”. Above all, the Board – and everyone else – needs to keep consulting with investors on criteria for inclusion, exclusion and recycling. That way – as the Canadians have warned – we may not reach a conceptual conclusion, but we might just reach a workable solution that preserves important performance measures and protects companies from the vagaries of their own accounts!