A company's statement of profit and loss, also known as its income statement, has its drawbacks. For the most part, the statement accurately reflects a company's past profitability and earnings growth — one of the primary determinants of a firm's stock performance — but it remains a subjective measure, open to manipulation. In particular, companies have a fair amount of latitude on the timing and impact of the quarterly and annual charges and other expenses reported on the statement.
How a firm generates revenues and turns them into earnings is an important factor, but there are other important considerations. The Financial Accounting Standards Board (FASB) has continued to emphasize a financial measure called other comprehensive income (OCI) as a valuable financial analysis tool. The FASB's stated goal, in general, is to issue guidance "to improve the comparability, consistency, and transparency of financial reporting." To accomplish this, it has sought to "increase the prominence of items reported in other comprehensive income."
The Basics of OCI
Other comprehensive income can be seen as a more expansive view of net income. In the past, changes to a company's profits that were deemed to be outside of its core operations or overly volatile were allowed to flow through to shareholders' equity. OCI provides important details on these figures.
Bear in mind that OCI is not the same as comprehensive income, though they certainly sound alike. Comprehensive income is simply the combination of standard net income and OCI. As such, it is literally a more comprehensive and holistic view of the drivers of a company's operations and other activities that are an integral component of its economics.
Back in June 1997, the FASB issued FAS130 on how to report comprehensive income. The FASB's technical definition of comprehensive income is "the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners."
OCI can be found as a line item on a company's balance sheet. Specifically, it is located under the equity section of the balance sheet as well as under a related statement called the consolidated statement of equity.
In more recent years, in addition to the standard balance sheet reporting conventions, companies received a couple of other ways to present OCI in their financial statements: They can either list the individual line item components along with the income statement (such as at the bottom of the income statement) or present OCI on its own separate page. These measures are also part of a long-term goal to help the U.S. generally accepted accounting principles (GAAP) align more closely with International Financial Reporting Standards (IFRS) as administered by the International Accounting Standards Board (IASB).
Real-Life Example of OCI
To better illustrate the specific components of OCI, let's look at a statement from MetLife. In 2012, one of its 10-K filings with the Securities And Exchange Commission (SEC) detailed standard net income of $6.7 billion as well as accumulated other comprehensive income of around $5.9 billion, $4.9 billion of which stemmed from its current fiscal year. That is a pretty significant driver of its overall profit levels for the year.
For the full year, the items that ran through comprehensive income included unrealized gains from derivatives instruments of $1 billion, unrealized investment gains of $4.5 billion, foreign currency translation adjustments of negative $100 million, and defined benefit plan adjustments of negative $500 million.
Accumulated Other Comprehensive Income
Important Categories of OCI
Understanding the drivers of a company's daily operations is going to be the most important consideration for a financial analyst, but looking at OCI can uncover other potentially major items that impact a company's bottom line.
Investment Gains and Losses
Insurance companies like MetLife, banks, and other financial institutions have large investment portfolios. Realized gains and losses are going to run through reported net income for the most part, but looking at the unrealized side of the equation can demonstrate how a company is managing its investments and if there is the potential for big losses down the road. In this respect, OCI can help an analyst get to a more accurate measure of the fair value of a company's investments.
Looking at OCI can also lend insight into firms that operate overseas and either do currency hedging or have sizable overseas revenues. In our example above, MetLife's foreign currency adjustment wasn't overly large, but seeing it could help an analyst determine the impact of currency fluctuations on a company's operations. For a U.S.-based firm, a stronger domestic dollar will lower the reported value of overseas sales and profits. Looking at results from a currency-neutral standpoint can help in understanding the actual dynamics of growth and profitability.
Another major category in OCI is the impact on corporate retirement plans. Years of negligible stock returns have placed the pension assets of a number of large corporations below the obligations they must cover for current and future retirees. Examples of these differences can demonstrate just how big the impact can be on a firm.
Case in point: In 2011, Goodyear reported a standard net income of $343 million, but a loss of $378 million when subtracting retirement plan expenses. In another report that year, industrial giant General Electric logged regular earnings of almost $14.2 billion but had those more than cut in half when factoring in losses on its retirement plans. The extent of future retirement liabilities is certainly an important consideration in estimating a firm's future profit prospects.
The OCI measure was also quite helpful during the financial crisis of 2007 to 2009 and through its recovery. For instance, coming out of the Great Recession, the banking giant Bank of America reported a $1.4 billion profit on its standard income statement, but a loss of $3.9 billion based on comprehensive income. The difference had to do with OCI and the unrealized losses that took place in its investment portfolio. Overall, it called into question the quality of the profit figures it held out as its real measure of capital generation for the year.
Assistant Professor of Business at Columbia Business School Sehwa Kim, in a report written alongside Associate Professor Seil Kim and Professor Stephen Ryan, found that "In response to the financial crisis of 2008, under Basel III regulations, unrealized gains and losses on available-for-sale ('AFS') securities recorded in accumulated other comprehensive income became included in banks' regulatory capital for advanced approaches banks. ... As a result, recent studies find that those affected banks reclassified investment securities from AFS to held to maturity ('HTM') or classified newly acquired securities as HTM to mitigate the increase in regulatory capital volatility. These studies suggest that OCI can be a significant factor affecting financial institutions' asset portfolio management."
The Bottom Line
Understanding and analyzing OCI greatly improve financial analysis, especially for financial companies. In an ideal world, there would only be comprehensive income as it includes standard net income and OCI, but the reality is that an astute analyst can combine both statements in their own financial models.
Existing disclosures to either detail comprehensive income and all of its components at the bottom of the income statement, or on the following page in a separate schedule, have made analysis easier. A number of accountants have questioned why OCI is listed as part of equity on the balance sheet, but if you look carefully, there are a number of places to locate it and help determine the health and total economics of the underlying company.