Net Income, Retained Earnings, Accumulated Other Comprehensive
Income, and Reserves In addition to contributed capital, earned capital not distributed in dividends is available to finance investing and operating activities. The following sections describe the reporting of earned capital
Net Income and Retained Earnings
Many of the financing events examined so far equity issues, share buybacks, and cash dividends are transactions with shareholders that change shareholders’ equity directly. Profitable investing and operating activities also lead to increases in shareholders’ equity via increases in net assets reported as net income on the income statement. Through the accounting closing process, net income is reflected as an increase in retained earnings on the statement of shareholders’ equity, which supports the balance in retained earnings reported on the balance sheet. PepsiCo’s 2012 consolidated statement of shareholders’ equity reconciles the balance of retained earnings at the beginning of 2012 ($40,316 million) to its balance at the balance sheet date, December 29, 2012, ($43,158 million). Net income of $6,178 million causes retained earnings (and thus, shareholders’ equity) to increase. Dividends declared on common stock, preferred stock, and RSUs decrease retained earnings.
Income, and Reserves In addition to contributed capital, earned capital not distributed in dividends is available to finance investing and operating activities. The following sections describe the reporting of earned capital
Net Income and Retained Earnings
Many of the financing events examined so far equity issues, share buybacks, and cash dividends are transactions with shareholders that change shareholders’ equity directly. Profitable investing and operating activities also lead to increases in shareholders’ equity via increases in net assets reported as net income on the income statement. Through the accounting closing process, net income is reflected as an increase in retained earnings on the statement of shareholders’ equity, which supports the balance in retained earnings reported on the balance sheet. PepsiCo’s 2012 consolidated statement of shareholders’ equity reconciles the balance of retained earnings at the beginning of 2012 ($40,316 million) to its balance at the balance sheet date, December 29, 2012, ($43,158 million). Net income of $6,178 million causes retained earnings (and thus, shareholders’ equity) to increase. Dividends declared on common stock, preferred stock, and RSUs decrease retained earnings.
Accumulated Other Comprehensive Income
Another component of shareholders’ equity, AOCI (accumulated other comprehensive income), is a consequence of standard setters allowing certain asset and liability revaluations (called other comprehensive income) to bypass the income statement and be reported directly in shareholders’ equity (as opposed to the treatment of items in net income, which first appear on the income statement and then are reflected as an increase in shareholders’ equity via retained earnings)..
Under U.S. GAAP, four items are disclosed as part of AOCI, and IFRS adds a fifth item:
Another component of shareholders’ equity, AOCI (accumulated other comprehensive income), is a consequence of standard setters allowing certain asset and liability revaluations (called other comprehensive income) to bypass the income statement and be reported directly in shareholders’ equity (as opposed to the treatment of items in net income, which first appear on the income statement and then are reflected as an increase in shareholders’ equity via retained earnings)..
Under U.S. GAAP, four items are disclosed as part of AOCI, and IFRS adds a fifth item:
- Unrealized gains and losses from investments in available-for-sale securities. Othercomprehensive income arises when firms experience unrealized fair value gains or losses on securities deemed available for sale . Each year, a firm will recognize in the statement of comprehensive income the net change in unrealized fair value gains or losses on available-forsale securities, which are reported cumulatively in AOCI. When the firm sells the securities, it eliminates the unrealized gain or loss account and recognizes a realized gain or loss in measuring net income.
- Unrealized gains and losses from translation of foreign financial statements during the consolidation process. U.S. firms with foreign operations usually translate the financial statements of their foreign entities into U.S. dollars each period using the exchange rate at the end of the period. Changes in the exchange rate cause an unrealized foreign currency gain or loss. Firms do not recognize this gain or loss in measuring net income each period; instead, they recognize foreign currency translation gains and losses in the statement of comprehensive income, and accordingly increase or decrease AOCI in shareholders’ equity. Presumably, using AOCI to capture such unrealized gains and losses minimizes the impact of the volatility of foreign currency exchange rates on reported profits while reflecting current values of assets and liabilities. If exchange rates reverse or the firm disposes of the foreign unit, it eliminates the unrealized foreign currency adjustment from AOCI and, in the case of a disposal, recognizes a gain or loss in net income.
- Unrealized gains and losses from certain hedging activities. changes in the fair value of cash flow hedges are also reported as other comprehensive income and accumulated in other comprehensive income on the balance sheet. When the hedged cash flows occur and generate an income statement effect, an offsetting portion of the AOCI is reclassified into current net income.
- Unrealized gains and losses from changes in certain pension assets and liabilities. Pension accounting is driven by changes in two key economic amounts, the pension liability, which is the present value of all future expected pension payments to retirees, and the pension asset, which is the fair value of cash and securities set aside to make those payments. Expected changes in the liability, determined by the discount rate used to compute the liability’s present value and the service credits earned during the period by current employees, and expected changes in the asset, determined by the expected return on asset investments, are reflected in current period net income through pension expense. Unexpected changes in the asset and liability, driven by changes in the discount rate, actual returns on assets, and changes in other actuarial assumptions such at mortality rates, are treated as unrealized gains and losses and reported in AOCI. They are amortized to current period net income over time
- Unrealized gains and losses from revaluations of long-lived operational assets (IFRS). IFRS permits periodic revaluations of fixed assets and intangible assets to their current market value). Increased valuation of assets leads to an increase in a revaluation reserve account included in the shareholders’ equity section of the balance sheet (similar to AOCI). Depreciation or amortization of the revalued assets may appear fully on the income statement each period as an expense or may be split between the income statement (depreciation or amortization based on acquisition cost) and a reduction in the revaluation reserve (depreciation or amortization based on the excess of current market value over acquisition cost
Given that total shareholders’ equity is the same regardless of whether the unrealized gain or loss immediately affects net income or affects another shareholders’ equity account (AOCI) and later affects net income, your primary concern with other comprehensive income is the appropriateness of revaluing the associated asset or liability and delaying recognition of its income effect. To the extent that the changes in AOCI are transitory (it is, after all, difficult to predict future changes in interest rates, market returns, and exchange rates), the amounts should be excluded from predictions of future earnings. However, you should consider whether management can control the timing of reclassifications of AOCI to current income.
Fluctuations in comprehensive income and AOCI reflect risks. The fluctuations are quantifications of the effect on value of the firms’ exposures to interest rate, market return, exchange rate, and commodity price risk. A look at a firms’ comprehensive income through time confirms that comprehensive income is generally far more volatile than net income.
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