ACC 545 Week 6 Comprehensive Income and Financial Reporting Example

$14 Million of Net Income, $10.8 Million of Comprehensive Income: Reporting Bond Losses, a Weaker Canadian Dollar, a Pension Remeasurement and a Swap Gain at a Composite Medical Equipment Distributor

[Student Name]

University of Phoenix

ACC/545: Financial Reporting

Week 6 Assignment

[Instructor Name]

[Date]

The distributor and all figures are composites written for a model paper; standards and research findings come from the sources listed.

A composite distributor sells hospital beds, patient monitors and infusion pumps to hospitals and clinics in the United States and, through a subsidiary, in Canada. It invests surplus cash in investment-grade bonds, sponsors a closed defined benefit plan for long-serving employees and fixed the interest rate on its term loan with a swap. This year its net income was $14.0 million. Its comprehensive income was about $10.8 million. The $3.2 million gap is not an error; it is a set of real changes in the company's value that the standards keep out of net income until they are realized. This paper prepares and explains the reporting.

What Belongs in Other Comprehensive Income

Other comprehensive income includes specific gains and losses that standards exclude from net income, usually because they are unrealized and may reverse. Comprehensive income is net income plus other comprehensive income, and the standards require it to be presented either in a single continuous statement or in two consecutive statements (Financial Accounting Standards Board, 2011).

Bonds Available for Sale

The distributor holds $60 million of corporate bonds classified as available for sale. As market yields climbed, the bonds lost $1.4 million of fair value that had not been realized by year end. In November, the distributor sold bonds with a previously deferred loss of $300,000, recognizing that loss in net income. To avoid counting it twice, a reclassification adjustment adds $300,000 back to other comprehensive income. The net pretax effect is a loss of $1.1 million.

The Canadian Subsidiary

The Canadian subsidiary uses the Canadian dollar as its functional currency, and its net assets of about C$40 million are translated into US dollars at the year-end rate. The Canadian dollar fell from 75 to 72 US cents during the year, producing a translation loss of about $1.2 million, reported in other comprehensive income. It would be reclassified to net income only if the subsidiary were sold or liquidated. Because the distributor intends to reinvest the subsidiary's earnings indefinitely, it does not record deferred tax on the translation adjustment.

The Pension Plan

The pension plan's obligation rose more than expected because the discount rate fell and retirees are living longer than prior mortality tables assumed. The resulting actuarial loss of $2.6 million is recognized in other comprehensive income. Part of the accumulated net loss from earlier years, $400,000, was amortized into net periodic pension cost this year, which is a reclassification from accumulated other comprehensive income into net income. The net pretax effect on other comprehensive income is a loss of $2.2 million.

The Interest Rate Swap

The distributor pays a fixed rate and receives a floating rate on a swap designated as a cash flow hedge of its variable-rate loan. As rates rose, the swap gained $800,000 in fair value, recorded in other comprehensive income. Of the accumulated gains, $200,000 was reclassified into interest expense as the hedged interest payments occurred, reducing that expense. The net pretax effect is a gain of $600,000.

Tax Effects

The bond, pension and swap items are taxable when realized, so deferred taxes apply at 25%. Their combined pretax effect is a loss of $2.7 million, with a tax benefit of about $675,000, for a net loss of about $2.03 million. Adding the $1.2 million translation loss, which carries no tax, total other comprehensive income is a loss of about $3.23 million. Comprehensive income is $14.0 million less $3.23 million, about $10.78 million.

Interim Reporting

The same items appear each quarter. Because interest rates and the Canadian dollar move continually, quarterly other comprehensive income swings more than net income, and the distributor presents comprehensive income in each interim report as the standard requires. Investors who follow the quarters can see, for example, that most of the year's bond loss occurred in the second quarter, when rates rose fastest, and that the translation loss reversed partly in the fourth.

Presentation

The distributor uses two consecutive statements: the income statement ending in net income, followed by a statement of comprehensive income that begins with net income, lists each component of other comprehensive income net of tax, with reclassifications shown separately or disclosed in the notes, and ends with comprehensive income. Accumulated other comprehensive income appears in equity, with a note rolling forward each component: beginning balance, other comprehensive income before reclassifications, amounts reclassified and ending balance, with the income statement line affected by each reclassification.

Why These Items Bypass Net Income

The standards keep these items out of net income for different reasons. Bond losses may reverse if rates fall before the bonds are sold or mature. Translation adjustments reflect currency moves on an investment the company intends to hold, not cash flows. Pension remeasurements arise from changes in long-term assumptions and are recognized in earnings gradually through amortization. Hedge gains are deferred so they reach earnings at the same time as the hedged interest payments, matching the hedge with what it protects. Each exclusion is a deliberate choice about timing, not a judgment that the amounts do not matter.

Effect on Ratios

Because accumulated other comprehensive income is part of equity, its decline reduced total equity by about $3.2 million this year. The distributor's loan covenant measures tangible net worth excluding accumulated other comprehensive income, so the loss did not affect compliance. Return on equity based on net income is slightly higher than it would be using comprehensive income, and analysts who follow the company are told both.

A Note on Stranded Tax Effects

When the federal rate fell from 35% to 21% in 2017, deferred taxes on items in accumulated other comprehensive income were remeasured through income tax expense, leaving tax effects in accumulated other comprehensive income at the old rate. A 2018 update allowed companies to reclassify those stranded effects to retained earnings (Financial Accounting Standards Board, 2018). The distributor made that election and discloses its policy for releasing tax effects from accumulated other comprehensive income.

Is Comprehensive Income a Better Measure?

Dhaliwal et al. (1999) tested whether comprehensive income was more strongly associated with share returns than net income and found little evidence that it was, except for the securities component in financial firms. For this distributor, the items in other comprehensive income arise mostly from interest rates, currency and pension assumptions rather than from operating decisions, which supports keeping them separate. Yet the pension loss and the bond losses are real changes in value that readers should not ignore.

Conclusion

Four items explain the $3.2 million gap between net income and comprehensive income: bond losses net of a reclassification, a translation loss from a weaker Canadian dollar, a pension remeasurement net of amortization and a swap gain net of reclassification. Presented in two statements with a component rollforward, they give readers a complete view of changes in equity from sources other than owners, while net income remains focused on realized performance.

References

Dhaliwal, D., Subramanyam, K. R., & Trezevant, R. (1999). Is comprehensive income superior to net income as a measure of firm performance? Journal of Accounting and Economics, 26(1-3), 43-67. https://doi.org/10.1016/S0165-4101(98)00033-0

Financial Accounting Standards Board. (2011). Comprehensive income (Topic 220): Presentation of comprehensive income (Accounting Standards Update No. 2011-05).

Financial Accounting Standards Board. (2018). Income statement, reporting comprehensive income (Topic 220): Reclassification of certain tax effects from accumulated other comprehensive income (Accounting Standards Update No. 2018-02).