It includes consideration of:

• The Conceptual Framework for Financial Reporting (Conceptual Framework)
• Income and expenses included in OCI and reclassification
• Arguments for and against reclassification
• Accounting mismatches
• Users’ views

The Conceptual Framework

The International Accounting Standards Board’s (IASB®) Conceptual Framework includes guidelines on how to present financial performance, including the role of OCI and whether income and expenses included in OCI in one period should be reclassified into the statement of profit or loss in a future period. Reclassification is sometimes also referred to as ‘recycling’. The statement of profit or loss and OCI is the primary source of information about an entity’s financial performance for the reporting period. Many users of financial statements incorporate profit for the year (net profit) in their analysis either as a starting point for that analysis or as the main indicator of the entity’s financial performance for the period. However, in order to understand an entity’s financial performance for the period, an analysis of all income and expenses is required including income and expenses in OCI.

The statement of profit or loss and OCI is designed to be useful to a broad range of users. In particular, users will often attempt to assess the future net cash inflows of an entity from this statement which should be understandable and comparable. An entity can choose to present a single statement of profit or loss and OCI or may present a statement of profit or loss and a statement of OCI separately. OCI should show separately those items which may be reclassified to profit or loss and those items which may not be reclassified. The related tax effects must be allocated to these sections.

Most items of income and expense are included in the statement of profit or loss. However, in certain circumstances, an IFRS^® Accounting Standard may require that income or expenses arising from a change in the current value of an asset or liability are to be included in OCI when doing so would result in the statement of profit or loss providing more relevant information, or a more faithful representation of the entity’s financial performance.

Income and expenses that are measured using historical cost are included in the statement of profit or loss. Additionally, income and expenses relating to a change in the current value of an asset or liability may also be included in profit or loss if an IFRS Accounting Standard allows or requires it. An example is an investment in another entity’s debt instruments where the investing entity has an objective of both collecting contractual cash flows and selling some of the investment in debt. Since the contractual terms of the debt instruments would give rise on specified dates to cash flows that are solely payments of principal and interest and the business model includes an element of selling the investment in debt, this investment would be measured at fair value through other comprehensive income in accordance with IFRS 9 Financial Instruments. With such an investment, the interest income which would be collected from holding the debt instruments is separable from other changes in value of the investment itself. In this case, interest income is included in the statement of profit or loss even though the gains and losses related to changes in fair value are presented in OCI.

Income and expenses included in OCI and reclassification

Generally, income and expenses included in OCI in one period are reclassified into the statement of profit or loss in a future period. This principle should result in the statement of profit or loss providing more relevant information, or a more faithful representation, of the entity’s financial performance. If, in producing an IFRS Accounting Standard, the IASB feels that there is no clear basis for reclassification then income and expenses included in OCI are not reclassified. Only the IASB can make the decision to report an item of income or expense in OCI by explicitly including this in an IFRS Accounting Standard.

An entity will typically incur various expenses as a result of its operations, including tax expenses, salaries and some provisions. If these expenses related to the entity’s operations are not reported in profit or loss, the statement of profit or loss would generally provide too positive a reflection of the cash flows an entity is generating. A faithful representation of the entity’s financial performance would normally require these expenses to be reported in profit or loss.

There are certain items that are not reclassified to profit or loss according to IFRS Accounting Standards. These include revaluation of property, plant and equipment (IAS 16 Property, Plant & Equipment), revaluation of intangible assets (IAS 38 Intangible Assets), and remeasurements of defined benefit plans (IAS 19 Employee Benefits). IFRS 9 provides examples of some items that are not reclassified and some items that are reclassified. For example, gains and losses from investments in equity instruments designated at fair value through other comprehensive income and changes in fair value attributable to changes in the liability’s credit risk for particular liabilities designated as at fair value through profit or loss, are not reclassified. However, the effective portion of gains or losses on hedges of net investments in foreign operations per IFRS 9 are reclassified as are the effective portion of gains and losses on hedging instruments in a cash flow hedge. Other items which may be reclassified to profit or loss include gains and losses on disposals arising from translating the financial statements of a foreign operation in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates.

Arguments for and against reclassification

There are arguments for and against reclassification. If reclassification ceased, then there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions could be left to specific IFRS Accounting Standards. It is argued that reclassification protects the integrity of the statement of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS Accounting Standards permit similar items to be recognised in either profit or loss or OCI.

Arguments against reclassification include that the reclassified amounts add to the complexity of financial reporting, may lead to earnings management, and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period.

The original logic for OCI was that it kept income-relevant items that possessed low reliability from contaminating the earnings number. Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of net income.

Accounting mismatches

An accounting mismatch occurs when assets and liabilities that are economically related are treated inconsistently for financial reporting purposes. For example, this could occur when an investment in another entity’s debt instruments is held in a business model whose objective is achieved by both collecting contractual cash flows and selling some of the debt instruments, with changes in fair value recognised directly in OCI, while a related liability is measured at amortised cost with changes in fair value not recognised. In such circumstances, an entity may conclude that its financial statements would provide more relevant information if both the asset and the liability were measured at fair value through profit or loss.

A mismatched remeasurement arises where an item of income or expense represents an economic phenomenon so incompletely that presenting that item in profit or loss would provide information that has little relevance in assessing the entity’s financial performance. An example of this is when a derivative is used to hedge a forecast transaction as part of a cash flow hedge; changes in the fair value of the derivative may arise before the income or expense resulting from the forecast transaction are recognised. Before the results of the derivative and the hedged item can be matched together, any gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective and qualifies for hedge accounting as a cash flow hedge, should be reported in OCI. Subsequently, those gains or losses are reclassified into profit or loss when the forecast transaction affects profit or loss. This allows users to see the results of the hedging relationship.

Users’ views

Some users think that OCI is confusing and see it as a black hole or ‘dumping ground’ for anything that is an accounting issue. There is a lack of clarity among users about the roles of profit or loss and OCI, and when OCI items should or should not be reclassified to profit or loss. A common misunderstanding is that the distinction is based upon realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS Accounting Standards. It may be difficult to deal with OCI on a conceptual level since the IASB themselves are finding it difficult to find a sound conceptual basis.

Many users do not analyse OCI items in detail because of a lack of understanding of OCI or because they do not consider them to be operating cash flows from which they can predict long-term trends. As a result, it can be argued that improving the presentation of OCI would not provide additional relevant information for their analysis.

There is a general lack of agreement about which items should be presented in profit or loss and in OCI. This is especially true of the principles behind reclassification which includes the logic of when and which OCI items should be reclassified. Users are confused by the lack of consistency and of a conceptual basis for the use of OCI in IFRS Accounting Standards. As a result, some users may feel that OCI is used to report controversial items. Users may pay less attention to OCI because some preparers give it less prominence than profit or loss as some entities provide less disaggregation and explanatory disclosures about items of OCI than items of profit or loss. This results in poor presentation and insufficient disclosures for OCI items.

Many users are thought to ignore OCI as the changes reported are generally not caused by the operating cash flows which can be assessed from other parts of the financial statements. Similarly, users may not analyse OCI items in detail either because of a lack of understanding of OCI or because they do not consider them to be operating cash flows from which they can infer long-term trends.

Written by a member of the Strategic Business Reporting examining team