Returning the Relevancy of the P&L

By Lurie, Ehud; Shuv, Shlomi | The CPA Journal, December 2010 | Go to article overview

Returning the Relevancy of the P&L


Lurie, Ehud, Shuv, Shlomi, The CPA Journal


A Proposed Model

Profit and loss (P&L) statements have always been significant for most reporting entities as the basis for evaluating the ability to generate future profits. This is evidenced by the various earnings multipliers that are often used in appraising companies and determining acquisition prices. Executive pay is often based on performance measured by the P&L. Performance under financial covenants and financial ratings relies on current profitability ratios. In addition, a company's P&L is the report most reviewed and examined by investors, credit providers, analysts, and the financial press. Although there have been many changes in performance measurement during the past few years, such as comprehensive income reporting, earnings per share continues to be calculated on the basis of net profit (loss) and likely will in the future.

The P&L is crucial to maintaining the public's trust in financial reporting. Any harm to the relevancy of the P&L would lead to a search for alternative solutions through various economic reports and nonGAAP adjustments.

The Rise of OCI

Over the past decades, the accounting profession began to use other comprehensive income (OCI) as a tool for deferring the recognition of certain profits and losses. Although many years have passed since the first use of OCI, no one has dealt with a conceptual framework to differentiate cases in which items are to be recognized in the P&L or defended to OCI. In recent years, new items are often added to OCI sporadically and without a structured methodology.

International Financial Reporting Standards (IFRS) have brought about a new phenomenon: Income and expenses are charged through OCI to equity and are not included in a future P&L. This represents a growing trend at the International Accounting Standards Board (LASB), the standards setter for IFRS. The only case in the past that used this unusual categorization was the revaluation of fixed assets. According to International Accounting Standard (IAS) 16, Property, Plant and Equipment, the revaluation model requires differences in the revaluation of fixed assets to be charged directly to equity, without recycling them to the P&L. Although the theoretical basis for this treatment was not provided in the past, one can assume that the capital reserve, derived from the capital preservation concept, does not recognize the revaluation of fixed assets as profit - unlike the financial capital concept, established in the Conceptual Framework. Accountants should keep in mind, however, that the revaluation model is veiy problematic and, therefore, rarely implemented by companies when they adopt IFRS.

Recent examples of this trend toward OCI can be seen in the following areas:

Actuarial profits or losses. According to IAS 19, Employee Benefits, entities can choose an accounting policy wherein imputed actuarial profits or losses are classified from retained earnings to OCI without recycling through the P&L. A proposed amendment to IAS 19 would make this accounting policy mandatory.

Measurement of financial assets. The recently published IFRS 9, Financial Instruments, allows entities to select an accounting policy whereby the investment in equity instruments may be measured at fair value and changes in fair value (except for dividends) are recorded to OCI without recycling through the P&L.

Credit risk. In accordance with the proposal for a new financial instruments standard, measurement of financial liabilities at fair value on the P&L will result in the interest component being charged to OCI, and it will not be recycled to the P&L in case of early extinguishment in the future.

In view of changes in the recently released IFRS for Small and Medium-sized Entities (SMEs) - which predict changes that will be adopted in full IFRS in the future - one can get a hint of this new nonrecycling trend. As published, IFRS for SMEs stipulates that translation differences accumulated from the translation of foreign operations will not be recycled to the P&L upon the realization of foreign activities, as opposed to the rule under IAS 21, The Effects of Changes in Foreign Exchange Rates. …

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