By P. Michael Moore, Keith Atkinson, and Wayne Nix

Of the two basic approaches to income measurement, the all-inclusive approach has generally been recognized as more useful to financial statement users than the current operating performance approach. The all-inclusive approach requires that all income items flow through the income statement before being closed to retained earnings. In recent years, however, FASB has promulgated several exceptions to the all-inclusive approach, allowing the income effects of certain transactions to be reported directly in owner’s equity.

To bring greater awareness to these bypass items and to aid financial statement users in assessing a firm’s activities and the timing and amounts of a firm’s future cash flows, SFAS 130 requires firms to disclose comprehensive income. Comprehensive income consists of traditional net income and the bypass items, called “other comprehensive income.”

Although firms are expected to apply accounting principles consistently, a firm is allowed to change an accounting principle when justified by economic conditions. When a change in principle is made, the cumulative effect is disclosed on the income statement for most changes, although it is a paper entry with no impact on cash flows or current operating activities. Moreover, some accounting changes are reflected on the income statement, while others are reported in the retained earnings statement.

Recognizing the “cumulative effect of accounting changes” as other comprehensive income statement items would both enhance the credibility of net income and provide greater consistency.

Cumulative Effect of Changes in Accounting Principle

Companies can change methods of accounting in response to economic or business conditions. The principle under APB Opinion 20, Accounting Changes, requires restating the affected balance sheet account to reflect the balance as if the new accounting principle had been used from the beginning; the offsetting debit or credit is reported in the income statement as the “cumulative effect of a change in accounting principle.” The cumulative effect is disclosed net of tax and presented as the last line item before net income.

Comparative income statements are not restated using the new principle; the firm must report, however, pro forma information on income and earnings per share as if the new principle had always been applied.

Exceptions for Certain Changes in Accounting Principle

The APB recognized that the cumulative effect of some accounting principle changes could be so large as to skew net income in a misleading way. Consequently, for certain exceptions, the cumulative effect, net of taxes, does not appear on the income statement. Instead, the cumulative effect is carried directly to retained earnings as an adjustment to the beginning balance. For example, when Chrysler Corporation changed from LIFO to FIFO, the cumulative effect of the change was $53.5 million. If the cumulative effect had been disclosed on the income statement instead of the retained earnings statement, Chrysler would have reported a net income of $45.9 million instead of a reported net loss of $7.6 million. In addition, all comparative income statements are restated using the new principle.

The following changes are exceptions that do not appear on the income statement:

Another exception is made for a change to LIFO. No cumulative effect is required due to the difficulty, if not impossibility, of such a calculation. The beginning inventory in the year of the change is considered the first layer, and LIFO is applied prospectively.

Evolution of Comprehensive Income

As early as 1936, arguments were made to support the all-inclusive or “clean surplus” concept, in which the income statement contains all changes in equity except for investments and dividend distributions. In Introduction to Corporate Accounting Standards (1940), Paton and Littleton state: “All determinants of income in the broadest sense—including unusual and irregular factors—should be reported in the income statement before the net results are passed to the stock-equity section of the balance sheet.” In Accounting Research Study 3 (1962), Sprouse and Moonitz state that “the net profit (earnings, income) of a business enterprise during any given period of time is the amount of the increase in the owners’ equity, assuming no changes in the amount of invested capital during the period either from price-level changes or from additional investments and no distributions of any sort to the owners.”

In 1966, APB Opinion 9, Reporting the Results of Operations, again emphasized the all-inclusive approach. The APB concluded that all changes recognized during the period should be reflected in the income statement, with the sole exception of adjustments of the income in prior periods. The APB later reaffirmed the all-inclusive approach in APB Opinion 20, Accounting Changes, and in APB Opinion 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.

The concept of “comprehensive income” was first introduced in 1980 in Statement of Financial Accounting Concepts 3 (superseded and replaced with Concepts Statement 6), Elements of Financial Statements. Comprehensive income was defined as “all changes in equity during a period except those resulting from investments by owners and distributions to owners.”

FASB has defined comprehensive income broadly, so that many items currently excluded from income determination could eventually be included. For example, appreciation in the valuation of plant assets could at some point be included in comprehensive income. SFAS 130, however, does not include any item that does not currently appear as owner’s equity. The Exhibit lists those exceptions that SFAS 130 requires to be reported as other comprehensive income.

Net income, as traditionally measured, continues to be reported in the income statement. Comprehensive income, consisting of “traditional” net income and other comprehensive income components, is displayed with prominence in the financial statements in one of three formats: combined with the income statement (one-statement approach); as a separate statement (two-statement approach); or included in a statement of changes in stockholder’s equity.

Time for a Change: A Proposal

Although one of the primary objectives of the income statement is to provide information to aid financial statement users in assessing future cash flows, the inclusion of the cumulative effect of a change in accounting principle in the income statement can be misleading in interpreting past results and is useless in predicting future cash flows. The cumulative effect of a change in accounting principle is simply a bookkeeping entry.

In addition to potentially misleading income statements, current GAAP permits inconsistencies because some exceptions go directly to retained earnings. With the availability of a comprehensive income statement, all changes in accounting principle should be shown as comprehensive income and omitted from the traditional income statement. This proposal would permit the comprehensive income statement to present an all-inclusive approach to comprehensive income, but would focus the traditional income statement on current operating performance.

The items currently considered as other comprehensive income are gains or losses that have not been realized and that may be offset in future years by other gains and losses. The cumulative effect of an accounting change is a one-time adjustment and will not be offset in future years. In addition, the cumulative effect is the result of income measurements and should ultimately be included in retained earnings. Consequently, the cumulative effect of accounting changes should be included in the comprehensive income statement and subsequently (in the same statement) transferred to retained earnings.