A Tale Of Two Bottom Lines

Foreword from ShareInvestor

This article “A Tale Of Two Bottom Lines” by Joyce Hooi was first published in The Business Times on 04 Aug 2009 and is reproduced in this blog in its entirety.

Investors confused as statement of comprehensive income jostles for attention with P&L

[SINGAPORE] The average investor in Singapore has probably started peering over his bifocals in bewilderment at the latest quarterly earnings from local firms since April.

Brow furrowed, he is wondering why he is seeing double this time – there is the familiar profit-and-loss statement and this new-fangled thing called a statement of comprehensive income. Suddenly, there are two bottom lines. And if the poor investor is especially unlucky, one is in the black and the other is in the red.

This change in financial presentation standards – and the attendant scope for confusion – is part of Singapore’s plan to align itself with the International Financial Reporting Standards (IFRS) by 2012.

Since Jan 1, companies have started reformatting their financial statements to fit the changes made to Financial Reporting Standard (FRS) 1.

Under this change, the balance sheet is now the “statement of financial position”, the income statement is the “statement of comprehensive income” – and the cash flow statement has been revolutionarily renamed the “statement of cash flows”.

The brow-furrowing, however, has largely taken place over the statement of comprehensive income, available in two format options.

Currently, most companies favour the option of slapping on a section called “other comprehensive income” with a resulting “total comprehensive income” after the usual profit-and-loss bottom line has been stated, effectively giving investors two bottom lines to worry about.

Other comprehensive income items are non-owner transactions like the changes in fair value of available-for-sale assets, and gains and losses in hedging and foreign currency translation changes.

SIA Engineering, for example, posted a net profit of $45.4 million on page one but total comprehensive income of $11.6 million on page five of its Q1 earnings report last month – after $36 million of foreign currency translation losses made their presence felt on the second bottom line.

Should fair-value losses exceed the net profit in the profit and loss (P&L) portion, the investor could end up looking at a net profit but a total comprehensive loss. A-Sonic Aerospace is one such company, posting a US$377,000 net profit for its Q1 but a total comprehensive loss of US$1.2 million due to foreign currency translation losses of US$1.6 million.

Prior to this revision in standards, these changes in fair value were lumped together with dividends and other owner related activity in the statement of changes in equity (SOCE).

SOCE was originally meant to reflect transactions with shareholders only, but companies, wary of the volatile nature of fair-value changes, began parking these items on SOCE where they had no business being.

SOCE, incidentally, is often found towards the back of the report, long after the reader’s concentration has flagged.

Now, the revised FRS 1 dictates that fair value changes can no longer be buried in SOCE but must be placed in comprehensive income where they will endure greater scrutiny.

“The other comprehensive income items are important for investors to look at because they are actually income and expense items, too,” says Tham Sai Choy, KPMG Singapore’s head of audit.

At the heart of this revision is the issue of how fair-value changes should be treated. As far back as 1991, accountants in the UK dithered over whether fair-value changes were operational and recurring items that did not belong in SOCE.

That this has taken 18 years to reach our shores says much about the magnitude of the dithering.

The matter was further muddied by the transfer of some fair-value changes to the P&L in the form of impairment losses, which revealed the arbitrary spirit of accounting.

“The issue of controversy was that if the value recovers in the future, the gains cannot be reflected in the P&L, but recorded in the fair-value reserve in SOCE,” says Mak Keat Meng, head of assurance at Ernst & Young.

And so the statement of comprehensive income was born – an awkward tool of appeasement and compromise, where gains and losses in fair value could play a role in the bottom line, jostling for attention with P&L items.

That the much-vaunted earnings per share and price-earnings ratios are still based on the P&L bottom line does nothing to clear up confusion – a point auditors themselves concede.

On the flip-side, the new format puts the salient items in one comprehensive statement for a more holistic view of the firm, says Kok Moi Lre, a partner at PricewaterhouseCoopers Singapore.

“The ‘other comprehensive income’ items reflect changes in net assets of the company. The increase in shareholder value is in the increase in overall net assets of the company – profit is only part of the story. Having the other comprehensive income items completes the picture,” says Ms Kok.

Few within the audit and analyst circles find the changes confusing, because they have long been aware of the need to dig into SOCE for a clearer picture.

“The new format just seems to be a way of giving auditors more work,” says one analyst.

For investors already reeling from the change, it is cold comfort to know there may be more dramatic changes to the numbers come 2011, says Penelope Phoon, head of ACCA Singapore.

“While the changes per se are necessary, changes in the formats over a fairly short period of time could cause some confusion when comparing financial statements over different financial reporting periods,” says Ms Phoon.

Investors can only hope the next change takes another 18 years to implement.