Since couple of decades ago, balance sheet started to showing a strange snippet on its Equity section called Accumulated Other Comprehensive Income. The snippet has been getting more and more popular although controversies and debates also emerged on the other hand. So, what is Accumulated Other Comprehensive Income, exactly, and why does it exist?
If you have been around with public-owned company for long enough, the snippet is certainly not a new stuff. But for those who haven’t just yet, this could be something new that you need to really understand before it comes its way to your desk.
The snippet is often included in the equity section of a balance sheet, in addition to the two major categories of contributed capital and retained earnings. Two major items—which are both of accounting controversy—in the snippet, are: (a) Foreign currency translation adjustment; and (b) Unrealized gains and losses on available-for-sale securities. These items are gains or losses that bypass the income statement when they are recognized. In this post I would like to discuss what “Accumulated Other Comprehensive Income” exactly is, why it exists in the balance sheet, and what foreign currency translation adjustment and unrealized gains and losses on available-for-sale securities are. Read on…
What is Accumulated Other Comprehensive Income?
Although the name says “comprehensive income”, in fact “accumulated other comprehensive income” IS NOT INCOME at all. It is an equity category that summarizes the effect on equity of certain market-related gains and losses. As mentioned on the preface, two major examples of item giving rise to the “accumulated other comprehensive income” are:
- Market fluctuations in the value of some investment securities—the accounts is called “Unrealized Gains and Losses on Available-for-sale Securities”; and
- Changes in the value of assets and liabilities held by foreign subsidiaries that are caused by exchange rate changes—the account is called “Foreign currency Translation Adjustment.”
Both “foreign currency translation adjustment” and “unrealized gains and losses on available-for-sale securities” are adjustment accounts. These adjustments have arisen on a case-by-case basis as part of the FASB’s effort to establish accounting standards that are accepted by the business community.
Many businesspeople are opposed to including these categories on the income statement because, they say, the income statement would become cluttered with gains and losses from market value changes, distracting from the purpose of the income statement, which is to focus on reporting profits from the activities of the business.
The compromise that allows market values in the balance sheet while keeping the income statement uncluttered is the creation of a separate category of equity called accumulated other comprehensive income.
Accumulated other comprehensive income is composed of certain market-related gains and losses that are not included in the computation of net income. It is important to remember that accumulated other comprehensive income is not income at all, but an equity category that summarizes the changes in equity that result during the period from market-related increases and decreases in the reported values of assets and liabilities.
An example of “Accumulated Other Comprehensive Income” snippet is shown below:
Next, let’s discuss each of the two major items in the snippet. Read on…
Foreign Currency Translation Adjustment
The foreign currency translation adjustment, in the accumulated other comprehensive income, arises from the change in the equity of foreign subsidiaries (as measured in terms of U.S. dollars) that occurs as a result of changes in foreign currency exchange rates. For example, if the Japanese yen weakens relative to the U.S. dollar, the equity of Japanese subsidiaries of U.S. firms will decrease, in dollar terms.
Before the 1980s, these changes were recognized as losses or gains on the income statement. Multinational companies disliked this treatment because it added volatility to reported earnings.
So, the FASB changed the accounting rule, and now these changes are reported as direct adjustments to equity on the balance sheet, insulating the income statement from this aspect of foreign currency fluctuations.
Unrealized Gains and Losses on Available-for-sale Securities
Available-for-sale securities are securities that a company purchased without intending to resell them immediately but also not necessarily planning to hold them forever.
When the FASB was considering requiring securities to be reported at their market values on the balance sheet, companies complained about the income volatility that would be caused by recognizing these changes as gains or losses on the income statement.
The FASB made the standard more acceptable to businesses by allowing unrealized gains and losses on available-for-sale securities to bypass the income statement and go straight to the equity section of the balance sheet.
The Statement of Comprehensive Income
A statement of comprehensive income provides a place, outside the regular income statement, for reporting all the unrealized gains and losses that are reported as equity adjustments. The statement is very new; U.S. companies have been required to present it starting December 31, 1998. An example of the statement is shown below:
Note that net income is one component in the computation of comprehensive income.
The appeal of comprehensive income is that this approach preserves the traditional income statement (calming the fears of the business community) but allows unrealized gains and losses to be reported. In essence, comprehensive income makes it possible to recognize unrealized gains and losses so that current market values can be reported on the balance sheet without having those unrealized gains and losses affect the income statement.