THE GLOBALIZATION IMPACT UPON THE FINANCIAL PERFORMANCE REPORTING. THE NET INCOME VERSUS THE COMPREHENSIVE INCOME
Solomon Daniela Cristina
University of Bacau, Faculty of Economic Sciences
Bacău, Roumania
Dragomirescu Simona Elena
University of Bacau, Faculty of Economic Sciences,
Bacău, Roumania
Abstract
In order to facilitate the analysis and the information’s increase of comparability offered by enterprise’s financial statement on all markets by all users of the accountancy information, the accountancy normalization organisms started a revision, harmonization and homogenization of financial performance statements project. This effort was materialized in IAS 1 “Financial Statements Presentation” paper that brings major changes in what the financial performance reporting is concerned, suggesting a new reporting pattern “The Statement of Comprehensive Income”. The present paper holds forth to approach precisely these aspects of enterprise’s financial performance reporting need in the frame of globalization, identifying the main limits/barriers that are placed in front of IFRS implementation, respective of the new performances reporting pattern in the European Union’s countries, such as:
- cost benefit rapport respective the equilibrium between costs and advantages represents one of the restrictions that has to be taken into consideration in presenting relevant and trustworthy information, IFRS implementation involving high costs, the advantages being difficult to quantify in this phase;
- conservatism: the new pattern of performances reporting based on comprehensive income should proof that is at least as useful as the traditional one based on net income;
- prediction character supposes the impact’s evaluation of the information provided by comprehensive income in decision making process, respective their use (of information) by analysts in financial predictions; recent studies proved the fact that the net result foresees the future cash fluxes better than the aggregated comprehensive income and its components.
Keywords: performance reporting , comprehensive income, net income, IAS 1
JEL classification: M42, M48
- INTRODUCTION
In the frame of globalization, world became smaller and smaller, the interdependence between states and the importance of connections between them increased and extended in a manner without precedent in history, imposing a global approach in the accountancy domain also. The main phenomena that govern the present accountancy reform process on world level are: normalization, harmonization, convergence, conformity and accountancy internationalization.
The International Accounting Standard Board(IASB), international settlement organism, initiated together with Financial Accounting Standards Board (FASB) several discussion projects that regard the realization of the complex convergence process realization. The publishing of International Accounting Standard 1 (IAS 1) “The presentation of financial statements” revised in September 2007 marks the finalization of the project’s first phase of revision and harmonization of financial statements presentation, bringing profound changes on the financial reporting performance, which is based on comprehensive income. The second phase that started already on the 16th of October 2008 in the same time with the publishing of the Discussion Paper (DP) Preliminary Views on Financial Statement Presentation is to examine and answers to fundamental questions connected to presenting the information in financial statements.
- CONCEPTUAL DELIMITATIONS CONCERNING PERFORMANCE
The performance notion is a complex one, due to different meanings that may have, according to the level from which is regarded: enterprise, management system, team, person etc. The performance represents a positive result, in favor of an action, that can be measured. The result may be looked into under two perspectives:
-Measure of investments’ performances, being identified with net income (profit or loss according to IASB);
-Measure of enterprise increase value, reflected through comprehensive income.
The general IASB frame does not define the net income (accountancy result), using for this the term “profit or loss”, being actually a component element of the comprehensive income, respective “un solde intermediaire”[13, p. 106].
A first definition for the comprehensive income is given by Statement of Financial Accounting Concepts No. 3 Elements of Financial Statements (SFAC 3) in December 1980, directive replaced afterwards by SFAC 6 (December 1985). SFAC6 defines comprehensive income as “the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity except those resulting from investments by owners and distributions to owners” [15, paragraph 70].
IASB defines the total comprehensive income as the change in equity during a period resulting from transactions and other events, other than those changes resulting from transactions with owners in their capacity as owners. Total comprehensive income comprises all components of ”profit or loss” and of ”other comprehensive income” [17, paragraph 7].
According to international accountancy referential, comprehensive income, reflects economic performance, which measures the patrimonial enrichment. The firm’s comprehensive income is determined as difference between the net assets from the period’s end and beginning, without the contributions from their share-holders and distributors, respective as difference between incomes and expenses, defined generically.
According to IASB general frame, “incomes” are economic advantages increases during the accountancy period under the form of assets’ growth or passives’ diminishing, that have as result the growth of own capitals under other forms than the growth derived from capital owners’ contributions” [14, p. 231], comprising not only the registered incomes, but also the unrealized earnings generated by operations that have as effect assets growth or debts diminishing, without generating an income – is the case of changes in revaluation surplus, actuarial gains on defined benefit plans, gains arising from translating the financial statements of a foreign operation, gains on remeasuring available-for-sale financial assets, the effective portion of gains on hedging instruments in a cash flow hedge [17, paragraph 7].
According to general IASB frame, “expenses are economic advantages decreasing during the accountancy period under the form of entries or diminishing of assets’ value, or of debts increases that have as effect the diminishing of own capitals under other forms than the distributions in the benefit of capitals’ owners” [14, p. 232], comprising both expenses and loss generated by operations that have as effect the assets decrease or debts increase.
The passing from net income(accountancy result) to comprehensive income allows on one side the future performance measurement because it takes into consideration not only the realized earnings, but the unrealized ones too, susceptible to produce in future, and on the other hand supposes the passing from evaluation in historic costs to evaluation to the fairvalue.
- CONVERGENCES AND DIVERGENCES IN FINANCIAL PERFORMANCE REPORTING
From the defining for the first time of the concept comprehensive income (in 1980) and up to the comprehensive income’s reporting 17 years have passed. The American normalizes’ efforts concerning the financial performance were materialized in June 1997 inStatement no. 130 “Reporting Comprehensive Income” – FAS 130. The companies placed under the incidence of FAS 130 may choose among three alternatives forms of reporting the comprehensive income [16, paragraph 22]:
- Combined statement of income and comprehensive income);
- Separate Statement of comprehensive income; și
- Included in statements of changes of stockholders’ equity).
After the adoption of FAS 130 the first studies appeared, studies that showed the companies’ preference for one of the three alternative reporting forms. Representative for this aspect is the presentation of a study realized in the United States in 2003. From the 615 companies listed on stock exchange that made the object of the study, 84% from the American companies and respective 72% from the Japanese onesregistered at the Securities and Exchange Commission of the United States preferred to present the comprehensive income in a statement of of stockholders’ equity (see table 1).
Table 1 Reporting Format of Comprehensive income
Reporting Comprehensive income / Companies US (2003) / Companies Japan(2003) / Number of companiesNumber of / Percent / Number of / Percent
In statements of changes of stockholders’ equity / 488 / 84% / 25 / 72% / 513
Separate Statement of comprehensive income / 69 / 12% / 8 / 23% / 77
Combined statement of income and comprehensive income / 23 / 4% / 2 / 6% / 25
Total Companies / 580 / 100% / 35 / 100% / 615
Source: AICPA Accounting Trends & Techniques - Annual Reports of US registrant of Japanese companies, :[10]
3.1Reporting the financial performance on international level
Applicable to all entities placed under the influence of International Financial Reporting Standards (IFRS), IAS 1 revised in 2007 was validated for annual periods that start from or after the first of January 2009 and brings profound changes on the situations concerning the financial performance reporting, materialized in changes in both presentation of changes in equity and presentation of comprehensive income, IAS 1 being in concordance with FASB requires presented by SFAS 130 Reporting Comprehensive Income.
The standard allows two alternative forms of reporting global performance [17, paragraph 81]:
(a) in the statement of comprehensive income, where both profit and loss and comprehensive income’s elements are found, or
(b) under two situations: - separate income statement
- comprehensive income statement that starts with profit and loss and continues with presentation of other elements of comprehensive income – OCI.
Boards IASB, FASB, after the preliminary discussions, suggested that all components elements of comprehensive income should be presented in just one situation of comprehensive income[4, p.60], therefore, will improve both the compatibility of the information presented in financial situations and the users’ ability of comprehension and use of information in their analyses, because ”they will need to look to only one financial statement for information on all non-owner changes in an entity’s net asset” [14, p.61].
On international level, the appearance of IAS 1 revised in 2007 established an unique frame, coherent and homogenous that offers for its users complete information regarding performance, financial position and cash flow for an entity, influencing the enterprises’ organizational dynamics, through elimination of redundancy, alternatives and conflicts from the Standards solving therefore several aspects concerning accountancy convergence.
3.2Reporting the financial performance in Romania
The 1st of January 2005 represents the beginning of IFRS application in European Union. Taking into consideration the necessity of assuring the conformity to national settlements in the accountancy domain with the European Union’s settlements, in the financial exercise of 2007, in Romania is continued the gradual implementation of International Financial Reporting Standards IFRS [19, art.1]. Starting with the 1st of January 2009 public interest entities placed under the incidence of IFRS will report the financial performance according to IAS 1 settlements, revised in 2007 and published in December 2008 in European Unions’ Official Journal.
In relation with state’s institutions, all entities, including those applying International Financial Reporting Standards prepare annual financial statements according to the IV-th Directive of European Economic Community, approved by the Public Finances Ministry’s Order nr. 1752/2005 and 2374 from 2007 with subsequent changes and completions, being a pattern imposed by law. For performance reflecting, societies should prepare an ”income statements” (”profit and loss account”), written as list, based on incomes and expenses classification according to their nature, these being presented as three types of activities: of exploitation, financial and extraordinary, the net incomebeing determined as pertinent indicator in reflecting the enterprises’ financial performance [18, art.37].
- NET INCOME OR COMPREHENSIVE INCOME?
The fundamental changes announced in financial reporting started numerous controversies that can be synthesized in the following three directions:
(A)Net income has higher value relevance than comprehensive income
(B)Comprehensive incomehas higher value relevance than net income
(C)Comprehensive income and net income have the same value relevance
- Net income has higher value relevance than comprehensive income
Net income and its subtotals such as operating income have been shown to have predictive value by numerous studies.
Cheng, Cheung, and Gopalakrishnan (1993) (US): the study takes under consideration the analysis of three measures concerning the result: operating income, net income, and comprehensive income. The research results proved two alternative scripts: (a) net income and/or operating income are superior to comprehensive income as a measure of performance, or (b) that investors are "fixated" on net income, thus ignoring comprehensive income.
Dhaliwal, D., K. Subramanyam, and R. Trezevant (1999)they find ”no evidence that comprehensive income is more strongly associated with returns/market value or better predicts future cash flows/income than net income. … Our results do not support the claim that comprehensive income is a better measure of firm performance than net income” [3].
Takashi Yaekura (2005): ”Comprehensive income, by definition, is inferior to net income as it includes non-recurring (potentially large) changes of fair value that are not relevant to the ability to generate net cash flows. Comprehensive income serves nobody. Comprehensive income cannot provide feedback value as the reported figure does not belong to the (parent company) shareholders. ”Comprehensive income, as performance measure, is meaningless and harmful to investors” [9].As argument for sustaining its affirmations, he makes reference to the words of well-known economist Sir John R. Hicks (1973), laureate of Nobel Price, that, through his theory does not recommend the use of comprehensive income:
”Property values, for instance, do not obey the laws of arithmetic; the value of one piece of property A plus the value of another B, when A and B are sold separately, are not necessarily equal to the value of A+B when they are sold together” [9].
Wang Yue (2006) - shows that in the majority of the investigated European countries comprehensive income is value relevant, but less than reported net income[11].
Jurgen Ernstberger (Germany, 2008) – the research result proves the fact that ”comprehensive income appears to provide no incremental value relevant information beyond net income in explaining stock returns; ”... concerning the components of other comprehensive income, only unrealized gains and losses from available-for-sale financial assets in the IFRS sample are clearly incremental value relevant” [5].
Igor Goncharov, Allan Hodgson (2008, Amsterdam) proves the fact that ”net income dominates aggregated comprehensive income as a shareholder valuation metric and in predicting cash flows” [7].
It is interesting to present the results of a study realized in Europe that had as purpose the identification of main indicators of performance including the financial predictions “Financial Highlights”. Financial institutions and insurance companies have been excluded, analyzing the research results, we may conclude the fact that sales are in the top of management preferences (for all the companies taken under study) and net income (86% among the companies) as indicators with the highest impact and informational value concerning the performance reporting, comprehensive result not playing a significant role in financial predictions (see table 2).
Table 2 Performance reporting in Europe
Performance indicators / Number of companies(in percents)
Sales / 100%
Net income / 86%
EBIT (Or Net Operating Income) / 40%
EBITDA (Gross Operating Income),Or “Adjusted EBITDA” / 40%
Operating margin / 30%
EPS (Earnings Per Share) / 60%
Source: European Financial Reportimg Advisory Group (EFRAG), Pro-Active Accounting Activities in Europe (PAAinE), Performance Reporting: A European Discussion Paper, March, 2009, p. 61]
B. Comprehensive incomehas higher value relevance than net income
Hirst and Hopkins 1998 - ”comprehensive income is useful for analysts only when it is reported as a separate statement but not useful when it is reported as part of the statement of changes in stockholders’ equity” [8].
Biddle and Choi (2006) also show that comprehensive income was incrementally value relevant even before the adoption of SFAS No. 130; they find that comprehensive income dominates other measures of income in explaining equity returns.
Dennis Chambers, Thomas J Linsmeier, Catherine Shakespeare and Theodore Sougiannis, (2007)they also find that the type of financial statement in which firms report other comprehensive income (OCI) and its components affects pricing, consistent with the conclusions of prior experimental research. However, our evidence suggests that investors pay greater attention to OCI information reported in the statement of changes in equity, rather than in a statement of financial performance[1].
Jong-Hag Choi, Somnath Das, Yoonseok Zang (2007), - ‘other comprehensive income’ reported under SFAS No.130 is ”incrementally useful in predicting one-year ahead net income” [2].
Ristea M. (2004) considers net income as “… an obsolete concept in financial performance evaluation because … it does not take into consideration the latent earnings and loss registered directly in own capitals” [14, p. 270] and the comprehensive income “extensive measure of enterprise performance” [14, p. 274], agreeing with the presentation of a single situation of comprehensive result concerning the financial reporting, for this stating that “The elimination from situation concerning the performance reflecting for several elements, as well as the changes on net active, others than those concerning transactions with owners is a defiance addressed to financial information” [14, p. 270].
C. Comprehensive income and net income have the same value relevance
Zimmermann and Volmer (2005) comprehensive income and net income have the same value relevance and O’Hanlon and Pope (1999) UK) report ” no incremental information content for comprehensive income components”[6, p.24].
Keiichi Kubota, Kazuyuki Suda, Hitoshi Takehara (2009)”net income is one of the most dominant income measures, and the incremental information content test shows other comprehensive income items have significant information content… other comprehensive income is useful information, while we cannot rank between comprehensive income and net income” [12].
Despite the contradictory opinions, both net and comprehensive incomes are relevant indicators in appreciation the enterprise performance offering users’ pertinent accountancy information. (see figure 1)
Source: Hiroshi Yamada, Performance Reporting (FASB/IASB):[10,p.23]
Figure1 Accounting information and valuation