Hiding Volatility in Earnings Just Got Harder
Depending on how you look at it, Bank of America Corp. last year had a $1.4 billion profit or a $3.9 billion loss. Both figures are accurate. The big difference is that the second one is harder to find in the company’s financial reports.
To locate the first number, known as net income, simply check the bottom of Bank of America’s income statement. The other figure, called comprehensive income, is buried deep in the company’s statement of changes in shareholder equity, where the loss is easy for readers to miss.
That system of financial reporting is about to change. Starting with first-quarter results, U.S. public companies will be required to give greater prominence to comprehensive income in their securities filings, under new rules passed by the Financial Accounting Standards Board. Unfortunately the board didn’t go far enough, because it still gives companies cover to claim that the two earnings metrics aren’t equally important.
While the issue might seem arcane, the implications are far-reaching. Before Fannie Mae and Freddie Mac were seized by the government in 2008, they had accumulated about $30 billion of comprehensive losses that they excluded from their conventional earnings and regulatory capital. Those losses helped doom the two housing-finance companies. Changing the rules to make such troubles more obvious can only help.
Comprehensive income is the change in a company’s equity during a given period, excluding the effects of new capital injections and dividend payments. In Bank of America’s case, last year’s figure included almost $5.4 billion of losses that didn’t count toward net income, such as a $4.3 billion decline in the value of certain debt and equity securities.
A year earlier, the pattern was reversed. Bank of America reported a $2.2 billion net loss for 2010. Comprehensive income was $3.3 billion, mainly because of unrealized investment gains. Such fluctuations, good or bad, represent real economic changes, even if they are not of a recurring nature. Yet investors tend to ignore them, because they are largely out of sight.
They won’t be as easy to overlook anymore. From now on, companies will have to show comprehensive income and its components at the bottom of the income statement or right after in a separate table. It’s a subtle, but important, improvement.
“These clearly are changes in wealth,” says Roman Weil, professor emeritus of accounting at the University of Chicago Booth School of Business. “Heretofore it has been buried in shareholder equity, which is incomprehensible to most people.” (The professor and I aren’t related.)
The accounting board for years has used comprehensive income as a dumping ground for items deemed too volatile to include in traditional earnings. Examples include changes in the values of corporate pension plans and foreign currencies, as well as certain derivative instruments and other investments.
The line distinguishing what gets included in net income and what doesn’t is arbitrary. The board has never defined the difference conceptually, and its decisions often have been tainted by politics. Most famously, in 2009, the board caved to congressional pressure by passing emergency rule changes so banks and insurance companies could expand the range of investment losses they could keep out of net income and regulatory capital.
Other companies with large gulfs between comprehensive and net income include General Electric Co. (GE) and Goodyear Tire & Rubber Co. (GT) GE reported net income of $14.2 billion for 2011, but only $8 billion of comprehensive income, mainly because of losses on retiree-benefit plans. Goodyear showed $343 million of net income -- and a $378 million comprehensive loss, because of pension expenses.
At the other extreme, the insurance company Genworth Financial Inc. (GNW) reported $2.8 billion of comprehensive income for 2011, which was more than 10 times its net income. Most of the difference was because of unrealized gains on securities classified as available for sale.
The big question is whether the new reporting format will change investors’ perceptions. Originally the board had proposed requiring that companies show comprehensive income at the end of the income statement, making it the new “bottom line” so to speak. The board backed down in 2010, however, in response to complaints from corporate executives who opposed putting conventional earnings in the middle of the income statement and giving comprehensive figures so much visibility.
Now companies will have two options. They can show comprehensive income and its pieces on the face of the income statement. Or they can break up the presentation into two consecutive statements and relegate comprehensive income to a separate page. The latter method would be the natural choice for companies that want to de-emphasize volatility in their results, especially large financial institutions or manufacturers with sizable pension plans.
This approach will also give companies an excuse not to disclose comprehensive income in their quarterly earnings press releases, which is a shame. Plus companies aren’t required to show comprehensive income on a per-share basis, as they must with net income. This is another way of giving companies the all-clear to downplay its importance.
“I would expect most companies to show two separate statements,” said David Zion, an accounting analyst at Credit Suisse in New York. “At least it will be in a somewhat consistent spot, and as a result of that it will get more attention.”
We should know soon.
(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)
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