Companies may be managing earnings by shifting potential income-statement losses to the other comprehensive income (OCI) part of their balance sheets, the authors of a new study of OCI find.
The report’s authors, Georgia Tech accounting professor Charles Mulford and graduate student Anna Babinets, infer from their findings “that companies are engaging in selective earnings management by reporting losses in OCI and excluding them from net income.”
One finding on which they base their assumption is that “losses are more likely to be reported on the statement of other comprehensive income than gains.”
Further, the losses reported under OCI soared in the three years they studied. In 2013, 2014, and 2015, the percentage of S&P 100 companies reporting a loss under OCI shot up from 46% to 81% to 85%, according to the Georgia Tech Financial Analysis Lab study.
Further, the mean and median losses recorded under OCI for two out of the three years were higher as a percentage of net income than were the gains. Unrealized investment losses and negative foreign currency adjustments were the main drivers of OCI losses, the study found.
To be sure, the study doesn’t provide evidence that more and more companies are intentionally attempting to make their earnings look better to investors by actually shifting earnings losses to OCI. Instead, it offers circumstantial evidence in the form of the mounting tendency for companies to report OCI and the big bang OCI assets produce when they are cashed in.
Broadly, OCI represents gains and losses generated outside of a company’s normal business operations, such as those spawned by a company’s shares before they’re sold. Under generally accepted accounting principles, OCI consists only of those “gains and losses that bypass net income on the income statement, but cause changes in stockholders’ equity.” Gains and losses stemming from investments and distributions by owners and to owners aren’t included in OCI, however.
“Our findings affirm a general tendency for companies to delay recognition of losses by keeping them in OCI. By leaving material losses ‘on paper,’ and out of earnings, companies can paint their performance in a more positive light,” according to the Georgia Tech study.
The authors found other possible clues of earnings management by tracing what happens after gains or losses are realized and therefore moved from the balance sheet onto the income statement. When OCI gains and losses were realized in net income — when shares were actually sold, for instance — “they often had a material impact on earnings,” they said.
They contend that the looseness of the standards for reporting OCI might be a factor enabling firms to spruce up their earnings beyond what their operations suggest their earnings should be. “Given the leeway that managers are afforded in deciding what elements of gain or loss are included in net income or in other comprehensive income, it is possible that they are managing the timing of the recognition of gains and losses in net income,” according to the study.
“That is, we may observe that losses are more frequently reported in other comprehensive income while gains are directed toward net income. If so, it would imply that net income is reported artificially at a higher level than would be obtained if all other comprehensive income gains and losses were recorded in net income as they occurred.”
But that leeway will be narrowing for fiscal years starting in 2018. Under a 2016 Financial Accounting Standards Board update, gains or losses on available-for-sale equity investments will have to be recorded in net income.
Mulford advises CFOs to proceed with caution, contending that the FASB update portends other strictures on their ability to keep losses from soiling their companies’ reported profits.