In this article we will discuss about Comprehensive Income:- 1. Concept of Comprehensive Income 2. Components of Comprehensive Income 3. Advantages.
Concept of Comprehensive Income:
Comprehensive income, also known as all-inclusive concept of income, is the change in equity (net assets) of an entity 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 distribution to owners. It is equal to revenues plus gains minus expenses and minus losses.
Overall enterprise performance is indicated by the amount of comprehensive income, that is, by increase in the amount of net assets resulting from transactions and other events and circumstances in the period (excluding the effects of investments by and distribution to owners).
The International Accounting Standards Committee in its IAS-8 (1978) entitled ‘Unusual and Prior Period and Items and Changes in Accounting Policies’ says:
“Under the all-inclusive concept, transactions causing a net increase or decrease in shareholders’ interests during the period, other than dividends and other transactions between the enterprise and its shareholders, are included in the net income for the period. Non-recurring items, including unusual items arising in the current period, prior period items, or adjustments related to changes in accounting policies, are included in net income but there may be separate disclosure of the individual amounts.”
“A truly comprehensive concept of income for a period must include all changes in owners’ equity from non-owner sources that are associated with the period and that can be measured reliably, regardless of the restrictions on recognition imposed by our present GAAP. Obvious candidates for inclusion are holding gains and losses on assets and liabilities, whether realised or not.”
Earnings, Net Income and Comprehensive Income:
In accounting literature, accurate definitions of and relationships between earnings, comprehensive income and present generally accepted concept of net income are not found. Table 4.3 presents the relationships among these three terms.
As it is clear from Table 4.3, the difference between net income as presently accepted and earnings is not a fundamental one. The difference is the inclusion in net income and the exclusion from earnings of the cumulative effect of certain accounting adjustments relating to past periods, e.g., adjustments arising from a change in an accounting principle such as change in the method of pricing inventory. In other respects, net income and earnings are synonymous.
On the difference between earnings and comprehensive income, the Financial Accounting Standards Board (USA) in its SFAC No. 5 says:
“Earnings focus on what the entity has received or reasonably expects to receive for its output (revenues) and what it sacrifices to produce and distribute that output (expenses). Earnings also includes results of the entity’s incidental or peripheral transactions and some effects of other events and circumstances stemming from the environment (gains and losses).”
Components of Comprehensive Income:
Comprehensive income is a useful measure of overall performance. However, information about the components that make up overall performance is also needed.
A single focus on the amount of comprehensive income is likely to result in a limited understanding of enterprise performance; information about the components of comprehensive income often may be more important than the total amount of comprehensive income.
Investors generally attach more importance to component parts of an enterprise’s income for a period than knowing the aggregate figure shown on the “bottom line” for it is knowledge about the composition of the aggregate that makes judgement about the “quality of earnings” possible.
“Quality of earnings” generally refers to the durability and stability of earnings. For instance, one company may have Rs. 1,00,000 income, all derived from continuing and recurring operations, another may have the same aggregate income derived from a one-time gain on redemption of debt. Most investors would give more value to the first income figure than to the second income figure. Although some generalisations can be made about components of income, the separate components will differ for different kinds of enterprises.
The components of comprehensive income usually consist of the following items:
(1) Items relating to an entity’s on-going major or central operations.
(2) Exchange transactions and other transfers between enterprise and other entities that are not its owners.
(3) Items that are unusual or that occur infrequently, but that do not qualify as “extraordinary items.”
(4) Items that can be estimated with only little reliability.
(5) Results of transactions in investments in other enterprises.
(6) Un-realised changes in the value of assets and liabilities, when these are recognised by the accounting model in use.
(7) Items relating to the payment or recovery of taxes.
The above list is not exhaustive. Among the above items, the “on-going major or central operations” are generally the primary source of comprehensive income. It should be understood clearly that what are major or central operations for one kind of enterprise are peripheral or incidental for another, and for some it may be difficult to know where to draw the line. For most businesses, gains and losses on the sale of company automobiles are incidental; for a car rental company they are central.
Transactions in marketable securities are incidental for a manufacturing business and central for an investment banker. Thus, what are revenues to one business enterprise are gains to another business enterprise. The various components of comprehensive income may differ significantly from one another in terms of stability, risk and predictability, indicating a need for information about these components of income.
Duff and Phelphs observe:
“In the practical world of business and investment, however, net income determined on all-inclusive basis contains too much “noise”, i.e., earnings (positive or negative) derived from developments outside the normal operations of the business, such as capital gains or accounting changes. These are generally nonrecurring over a period of time, so that the analyst places his primary emphasis on earning power as something that can be counted on from year to year. Thus, earning power is a second concept of earnings and the one most meaningful to the investor.”
Prior Period Items:
Prior period items are generally infrequent in nature. They should not be confused with accounting estimates which are, by their nature, approximations that may need correction as additional information becomes known in subsequent periods.
The charge or credit arising on the outcome of a contingency, which at the time of occurrence could not be estimated accurately, does not constitute the correction of an error but a change in estimate. Such an item is not treated as a prior period item.
AS-5. ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies’ (Revised) issued in February 1997 has made the following provisions with regard to prior period items:
1. The nature and amount of prior period items should be separately disclosed in the statement of profit and loss in a manner that their impact on the current profit or loss can be perceived.
2. The term ‘prior period items’, refers only to income or expenses which arise in the current period as a result of errors or omissions in the preparation of the financial statements of one or more prior periods. The term does not include other adjustments necessitated by circumstances, which though related to prior periods, are determined in the current period, e.g., arrears payable to workers as a result of revision of wages with retrospective effect during the current period.
3. Errors in the preparation of the financial statements of one or more prior periods may be discovered in the current period. Errors may occur as a result of mathematical mistakes, mistakes in applying accounting policies, misinterpretation of facts, or oversight.
4. Prior period items are generally infrequent in nature and can be distinguished from changes in accounting estimates. Accounting estimates by their nature are approximations that may need revision’s additional information becomes known. For example, income or expense recognised on the outcome of a contingency which previously could not be estimated reliably does not constitute a prior period item.
5. Prior period items are normally included in the determination of net profit or loss for the current period. An alternative approach is to show such items in the statement of profit and loss after determination of current net profit or loss. In either case, the objective is to indicate the effect of such items on the current profit or loss.
According to AS-5, extraordinary items are income or expenses that arise from events or transactions that are clearly distinct from the ordinary activities of the enterprise and, therefore, are not expected to recur frequently or regularly.
Extraordinary items are sometimes termed “unusual items.” Some examples of such items could be the sale of a significant part of the business, the sale of an investment not acquired with the intention of resale or a liability arising on account of legislative changes or judicial pronouncement etc. The nature and amount of each extraordinary item are separately disclosed so that users of financial statements can evaluate the relative significance of such items and their effect on the operating results.
Income or expenses arising from the ordinary activities of the enterprises though abnormal in amount or infrequent in occurrence do not qualify as extraordinary. An example of such an item would be the write off of a very large receivable from a regular trade customer.
The following guidelines are contained in AS-5 with regard to extraordinary items:
1. Extraordinary items should be disclosed in the statement of profit and loss as a part of net profit or loss for the period. The nature and the amount of each extraordinary item should be separately disclosed in the statement of profit and loss in a manner that its impact on current profit or loss can be perceived.
2. Virtually all items of income and expense included in the determination of net profit or loss for the period arise in the course of the ordinary activities of the enterprise. Therefore, only on rare occasions does an event or transaction give rise to an extraordinary item.
3. Whether an event or transaction is clearly distinct from the ordinary activities of the enterprise is determined by the nature of the event or transaction in relation to the business ordinarily carried on by the enterprise rather than by the frequency with which such events are expected to occur. Therefore, an event or transaction may be extraordinary for one enterprise but not so for another enterprise because of the differences between their respective ordinary activities.
For example, losses sustained as a result of an earthquake may qualify as an extraordinary item for many enterprises. However, claims from policyholders arising from an earthquake do not qualify as an extraordinary item for an insurance enterprise that insures against such risks.
4. Examples of events or transactions that generally give rise to extraordinary items for most enterprises are:
i. Attachment of property of the enterprise; or
ii. An earthquake.
The ‘comprehensive income’ concept covers several types of income which have varying degrees of significance for the investors. Sometimes it is suggested that a tripartite form of income statement should be prepared in which operating income, holding gains/losses and extraordinary items would be separately reported.
In this income statement format, the main advantage is the clear separation of operating earnings—earnings power—from other types of income. This will be more useful to the investors, creditors and other users who are primarily concerned with earning power, than the one number, all-inclusive net income.
Advantages of Comprehensive Income:
Many arguments have been advanced in support of measuring comprehensive income of a business firm:
(i) The annual reported net incomes, when added together for the life of the enterprise, should be equal to the total net income of the enterprise.
(ii) The omission of certain charges and gains from the computation of net income lends itself to possible manipulation or smoothing of the annual earnings figures.
(iii) An income statement that includes all income charges and credits recognised during the year is said to be easier to prepare and more easily understood by the readers. This is based on the assumption that accountants statements should be as verifiable as possible; several accountants working independently on the same figures should be able to arrive at identical income figures.
(iv) With adequate disclosure of items influencing the comprehensive income, the financial statements users is assumed to be more capable of making appropriate classification to arrive at an appropriate measurement of income.
(v) The distinction between operating and non-operating transactions influencing the income is not clear-cut. Transactions classified as operating by one firm may be classified as non-operating by another firm. Furthermore, items classified as non-operating in one year may be classified as operating by the same firm in a subsequent year. This, in itself, leads to inconsistencies in making comparison among different firms or over several periods for the same firm.
Advocates of the all-inclusive concept claim that reporting in the income statement of all items affecting the shareholders’ interests during the period, other than dividends and other transactions between the enterprise and its shareholders, provides more useful information for the users of financial statements to enable them to evaluate the importance of the items and their effects on operating results.
Although the all-inclusive concept is generally supported, there are circumstances in which it may be considered desirable to report certain items outside the income statement for the current period. However, unusual items are generally included in net income.