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Narrow Net-Income Reporting Can Misguide Investors: Study

By excluding components of other comprehensive income, corporations may be overstating their financial performance.

Comprehensive income — net income plus other sources of income not likely to happen again — often gets decent billing on corporate financial statements these days.

But publicly held companies typically give the non-net-income portions of comprehensive income much less prominence than earnings. The “key focus for measuring financial performance remains with net income,” according to a new report by the Georgia Tech Financial Analysis Lab.

Net income, however, excludes what’s known as “other comprehensive income” (OCI): gains or losses stemming from foreign currency conversion; cash-flow hedges; securities that are available for sale; and pensions and other post-retirement benefits.

And that can confuse investors, according to the study, which looks at the elements of OCI for the S&P 100 companies from 2010 to 2012 . “Because net income excludes gains and losses that are often quite material, evaluations of financial performance based on net income may be misguided,” its authors state.

In fact, these big companies are much more prone to report OCI as a loss than as a gain. The study finds that the corporations studied reported OCI as losses 60 percent of the time, and were more than 5 percent of net income in about 38 percent of the cases studied. 

The components of OCI  are often excluded from net income because of their volatility. But Charles Mulford, director of the Georgia Tech Financial Reporting & Analysis Lab and one of the authors of the report, noted that these income areas should be considered by analysts when evaluating a firm’s full financial performance as well as by CFOs in judging how a competitor may record a certain kind of income.    

For some companies, the impact of OCI losses can be stunning. For example, Bank of America had the largest OCI losses in 2011 –$5.3 billion, or 371 percent of net income. The big bank’s OCI losses mainly stemmed mostly from unrealized losses on available-for-sale securities, the report said. 

General Dynamics and Dow Chemical had the highest losses in OCI in 2012, both of which were mainly the result of downsides in their pension and post-retirement benefit plans. General Dynamics reported losses of $1 billion in 2012, or 308 percent of net income. Dow had losses of $1.5 billion, or 138 percent of net income.      

During the period studied, “stock prices tended to go up and yet these companies are reporting for the most part losses in other comprehensive income, Mulford told CFO. ”The gains are ending up in income. The ones that are losses are remaining in other comprehensive income,” he thinks.

The consequences of such actions could be dire. With losses left out of net income, corporations could be “overstating” their financial performance, he says. “What we’re seeing with this study is there’s a big difference for many companies between total comprehensive income and net income. There’s much talk about how stock prices are getting over-valued based on price-to-earnings [ratios, but] they are really overvalued if you look at it compared to total comprehensive income,” he says.  

All areas of OCI in the study showed losses, with pensions and other post-retirement benefits coming in the highest at 81 percent of the cases. That was followed by losses in foreign-currency translations, 63 percent; cash-flow hedges, 57 percent; and available-for-sale securities, 53 percent.

Mulford says he’s not too surprised that pension obligations are spawning big losses, considering the currently low interest-rate environment. “There’s a lot of hand-wringing about how underfunded pension plans are. But I think once rates start to move back up, suddenly pension plans are going to be much better funded,” he said. That’s because rising interest rates will improve the funded status of pension plans (which are largely invested in bonds), not because corporations will be contributing more to the plans, he noted.

But consistent losses in other sectors, however, are not so easily explained, he adds. Since the dollar did not trend consistently higher during the sample period, he says, foreign currency losses would not be any more likely than gains. And with debt and equity prices tending to improve during the sample period, according to the report, it should portend a higher likelihood for gains on available-for-sale securities than losses.   

The report notes that regulatory efforts by the Financial Accounting Standards Board (FASB) called for giving the components of OCI more prominence in financial statements. FASB, in accordance with the International Accounting Standards Board (IASB), came up with requirements in 2011 to report OCI in one of two ways. One of the ways is a single statement that explains total net income and provides a total for comprehensive income. The other choice is a two-statement system in which OCI components are shown in a statement separate from the one that presents net income and total net income.

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