Question

Lendex Electronics (LE) had a great deal of turnover of top management for several years and was not followed by analysts during this period of turmoil. Because the company’s performance has been improving steadily for the past three years, technology analyst Steve Kent recently reinitiated coverage of LE. A meeting with management confirmed Kent’s positive impression of LE’s operations and strategic plan. Kent decides LE merits further analysis. Careful examination of LE’s financial statements revealed that the company had negative other comprehensive income from changes in the value of available-for-sale securities in each of the past five years. How, if at all, should this observation about LE’s other comprehensive income affect the figures that Kent uses for the company’s ROE and book value for those years?

Answer 1

The question deals with understanding how material is Other Comprehensive Income (OCI) in determining overall financial health of an organization and making an informed decision with respect to existing or future investment in an organization.

In the past, FASB had issued FAS130 guidelines as to how Comprehensive Income should be reported. FASB's definition of Comprehensive Income is a bit more technical and in the period under consideration, it is depicted by change in net assets due to transactions and events & circumstances resulting from sources other than owners. It specifically excludes changes in resulting from investments by owners and distribution to owners. Thus, standard accounting, reporting and investment practices were based on and consisted of reported normal or standard income from operations of an organization in Income Statement. It is the income mainly derived by an organization from its core and regular business operations. This normal income from core operations, as such, depicts an organizations past profitability and its growth over the period under consideration. Whereas, the many of items consisting of OCI were and are, normally, not reported in Income statement but were and are reported under Equity section of the Balance Sheet. Important and significant examples of OCI are investments gains/losses, currency rate fluctuation gains/losses, pension plan investment exposures, etc. Most of the prior practices showed this impact only in Balance Sheet not in Profit & Loss Account or Income Statement.

Due to financial crisis of 2000 and 2008 and various other factors there is a sea change and resulting in paradigm shifts in overall thinking of financial communities which demanded better models of reporting, more disclosure and transparency. Further, quite undeniably, there is an inherent need and urgency for seeking alignment between US Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) issued by International Accounting Standards Board (IASB). IAS 1 issued in 2007 requires mandatory reporting of OCI of all EU listed companies. The financial world is pressured to march towards this goal as this would result in a much better globally transparent business environment.

Due to above type of various scenarios and vast globalization and standardization of various practices, it was felt in financial circles, various nations and across industries that a very subjective view of profitability and growth was and is available from traditional income statements. However, for a layman or investor, Comprehensive Income is normal income from operations plus OCI. These developments led to introduction of few other ways of reporting OCI in financial statements as compared to previous way of reporting in Balance Sheet. Mainly, this allows organizations to report OCI in Income Statement at the bottom or as a separate schedule of its own.

With this background info, let us come back to what question is really asking is and it is whether the negative comprehensive income from changes in value of available-for-sale securities during the past year should impact the figures the analyst (i.e. Kent) uses for company's ROE and book values for those years. It appears that these securities are not yet sold are held. This means that, at present, the loss is unrealized as such and it shall be realized only when the company sells the same or securities are redeemed at their maturity as the case may be going forward.

Therefore, to answer the question, the ROE and book value of past years shall not change as the OCI loss is unrealized. However, Kent should highlight the relevant negative exposure to OCI from changes in value of available-for-sale securities in his report. This shall make current and potential investors aware of potential for realized loss on these securities and they shall be able to make an informed decision on the investment.