1. The dilemma of B/S problems and I/S problems
One of the most important issues in a today's financial accounting, not only for accounting institution but for accounting theory, is an introduction of fair value accounting. Whether we should take the issue as a problem of financial accounting or simply as a problem of provision of useful information of economic substance or risk to investors is a different matter. If we regard it as one of the essential problems in financial accounting, we have to discuss it with I/S (income determination) problems as well as B/S problems, whereas as a matter of reporting useful information for investors, we do not necessarily need to consider I/S problems. Disclosing the economic substance or risk apart from the income determination is substantially possible, because there is no necessity that the disclosure has to be made in the financial statements. The important point here is whether valuable information for investors is offered or not.
Meanwhile, major 3 accounting standard setters, namely, IASC, FASB (US), and ASB (UK) have released respective plans of "the second" income statement in succession. Each drafts are as follows (described in order of their publication).
①ＩＡＳＢexposure draft: Statement of principle for Financial Reporting (Oct.1995)
…Statement of Total Recognised Gains and Losses
②ＦＡＳＢexposure draft: Reporting Comprehensive Income (June,1996)
…Comprehensive Income Statement
③ＩＡＳＣ>exposure draft: Presentation of Financial Statement (July,1997)
…Statement of Non-owner Movement in Equity
These statements newly proposed are regarded as the 4th primary financial statement followed by B/S, I/S, and Cash Flow Statement. These statement also can be said as "the second" Income Statement against the traditional Income Statement. There is an anguish issue underling in these proposal: how would the introduction of fair value accounting be dealt with in relation to the conventional I/S. There is also a resolution of a dilemma of B/S problems and I/S problems in these proposals: there is a need to report(derivative）financial instruments at fair value on B/S, while there is also a requirement to preserve the framework of conventional income on I/S.
2. Why is "the second" Income Statement needed?
To explain this subject, first we need to remind of this following formula: Comprehensive Income = Net Income + Other Comprehensive Income…(1). Regarding the conventional I/S as a statement of net income, this newly proposed comprehensive income statement can be considered as a statement of other comprehensive income: the statement of comprehensive income = the statement of net income ("the first" income) + the statement of other comprehensive income ("the second" income)…(2). Important matters here are that the comprehensive income is divided into two parts, and the statement for "the second" income will be newly disclosed as the 4th primarily financial statement. In this context, I want to look at what is the other comprehensive income which is distinguished from the net income and why is it differentiate from the net income. Moreover, I would like to consider the necessity of reporting it as one of the primarily financial statements.
As for the items included in the other comprehensive income, items in current practices such as foreign transaction adjustment, unrealized gains (losses) on securities, and minimum pension liability adjustment will be included in it: these items have exceptionally put into an independent items in Equity on B/S but bypassed the present I/S (net income statement). It means that these items have shown respectively and individually in the Equity on B/S: they are neither paid in capital nor retained earnings, in other words, they are neither capital nor income (in terms of net income). In this substance, these items can be considered as the items which have been in "the gray (ambiguous) zone" between capital and income. And the conversion from the gray-zone indication to precise way － that is, on B/S, three parts consists of (i) (paid in) capital, (ii) retained earnings, and (iii) accumulated other comprehensive income should be clearly defined, while on I/S, the change statement of (iii) be disclosed as "the second" income statement － is the main scheme of this conception.
Thus, there is a contradiction that certain type of increase or decrease of equity arising from the fluctuation of fair value of assets or liabilities are indicated in Equity on B/S individually but not included in I/S. Recently such a contradiction are actualized due to the rapid increase of individual items on Equity caused by the need of reporting（derivative）financial instruments at fair value. This series of plans reflect their concern toward such a individual item in Equity which might be settled as "a saucer of the contradiction". To resolve the contradiction noted above, they decide to establish "the second" income statement which does not bypass income statement but is different from the net income statement (existing I/S).
3. The Second Income and its New Recognition Framework
The idea of "the second" income statement represents explicitly two types of income as described in equation (1). They are different in the nature and therefore the latter have to be disclosed as the 4th primary statement. Then, why the other comprehensive income has to be distinguished from the net income? Where does the heterogeneity in them come from? These matters are of great importance in the accounting theory.
By the way, conventional framework of periodical income determination is based on historical cost/realization principle (historical cost accounting), namely the historical cost would be recorded and reported on B/S until the goods or products are sold and the profit (or losses) realized. Therefore, if we were to evaluate financial instruments such as marketable securities at fare value, there is two ways to make it theoretically founded. That is, one is "realizability criteria" which is an expanded interpretation of existing realization concept and another is settlement of new criteria which is based on the heterogeneity between financial instruments and non-financial assets (expendable assets) to which conventional realization principle is applied.
I think conventional cost/realization framework does not fit to the recognition of gains and losses resulting from the price fluctuation (mere price difference). Because the framework is originally applied to expendable assets, even if financial instruments are also called "goods", it seems hard for me to make an enlarged interpretation for the framework (realization criteria →realizable criteria) to have apply in the today's financial instruments. Today as the weight of financial instruments among whole assets increased, it seems a new idea of setting up the separate framework for recognition/measurement of financial instruments has been increasing. This trend is ,for example, found by the recent comment (March 26) released by a chairman of the exposure draft committee in IASC. It is mere that the argument about today's fair value accounting represented by the valuation of financial instruments is not a same argument as the price change accounting in 1970's which is substantially opposed to the historical cost accounting even though both of them deal with the current value. It implies that today's argument about fair value accounting does not apply to the opposing diagram of "fair value accounting vs. historical cost accounting". In other words, fair value and historical cost can compatibly coexist in the new recognition framework stated above.
The today's argument on fair value accounting would become more important stage hereafter: it get into stride from disclosure criteria to the more substantial recognition/ measurement criteria. Among this trend, in Japan, footnote disclosure about derivative transactions is obliged from March 1997 by the amendment of The Rules of the Form and Content of the Financial Statements (July, 1996) in order to supplement the disclosure. However, with above mentioned movement of IASC and others considered, Japan will be required to establish not only the present disclosure criteria but also the recognition/measurement criteria in a near future. In that case, Financial Accounting Standard for Business Enterprises (as amended 1982) will be required to reexamine to fit to these framework. The revision itself has to be supported by the definite theory because it involves fundamental problems in accounting theory and should not have to be settled just by a reason of "the external pressure" (just to fit to the international standard). Particularly, the settlement of new criteria for income recognition arising from the introduction of fair value accounting and its theoretical support shall be needed. And if the second income statement would be indispensable, dividing rules for 2 types of income which are the components of comprehensive income must be prescribed clearly: distinction within (comprehensive) income itself in addition to the most important rule, the distinction between capital and income.
Appendix: Three Fundamental Issues of Comprehensive Income
In this Appendix, we would like to describe comprehensive income from three layers point of view and clarify three fundamental issues shown as follows (see Figure 1).
1) what is the difference between net income A (the first layer) and net income B (the second layer) ?
2) what is the difference between net income B (the second layer) and other comprehensive income C (the third layer) ?
3) What is the “recycle” issue?
Figure 1 Three layers view-point of comprehensive income
The first issue relates to the difference between the income recognition of the arrow ① and the arrow ② as shown in Figure 1. The arrow ① shows income accruing from the operating activities on investing (i)real or non-financial assets (internal investing) which is based on the “cost/realization” principle as the traditional principle of income recognition/ measurement. On the contrary, the arrow ② shows income accruing from the financing/ speculating activities on investing (ii)financial assets (external investing). The problem here is that what is the income recognition/ measurement principle in the second layer, and why does the income constitute the net income same as the one in the first layer. For financial instruments represented by securities and especially for derivatives, for instance, are there any cost which will be expense? Can the “matching principle” of revenue and expense be applicable to such assets same as real assets? Doesn’t mere recognition of gains/ losses exist there? As to the property of financial risk assets, in comparison with real or non-financial assets the cost of which will be expense in future financial period, could we say that they are the assets which accrue gains/ losses but the cost of which will not be expense? From the view point of the above questions, the traditional “cost/ realization” framework for real assets are not always applicable to the recognition/ measurement of gains / losses for financial risk assets. This problem will be appeared as how the “cost (expense) ” issue be explained in the argument based on the re-examination of the cost/ realization concept (the expansion approach of cost/realization framework) which focuses only on the “realization (revenue)” issue.
The second issue relates to the fact that there are two different types of income accruing from financial assets shown as the arrow ② and ③ in Figure 1: (ii)net income B (the second layer) and (iii)other comprehensive income C (the third layer). Then, how can the distinction between ② and ③ be theoretically explained? This example can be seen in the distinction between the two types of securities as explained in FAS No.115 (para.13): trading securities and available-for-sale securities. The different types of income accruing from these different types of securities are based on the distinction of short-term holding (securities “for profit”) or long-term holding (securities “for control”). The distinction on such two types of income is basically different from the distinction on the reporting such as current assets/ liabilities and fixed assets/ liabilities. However, it can be said that a principle on the income distinction can not be theoretically explained. We also can not find a principle of income recognition/ measurement in the explanation, for example, that other comprehensive income C is distinguished or deferred in order to avoid a volatility of net income until it is realized to be net income.
This relates to the third issue. That is, making the distinction between income B and income C until the latter is realized is exactly the method as called “recycle”. In that sense, there are no substantial difference between B and C (see the dotted line between them in Figure 1). On the contrary, the “non-recycle” method does not transfer income C to net income when it is realized. In that sense, the method makes a clear distinction between them (see the solid line between them in Figure 1), but it has no difference with the recycle method in a sense that income C is transferred directly to retained earnings of equity on B/S. Therefore, as long as the items of other comprehensive income are transferred to net income or retained earnings when they are realized, it can be said that they are not completely different type of income. For example, “foreign currency adjustment” described in FAS No.52 is unrealized income until foreign subsidiary company is sold or liquidated. It may take much time for such unrealized income to be realized, but the process of “unrealized income(P/L)→ accumulated other comprehensive income(B/S)→transfer to net income (P/L) or retained earnings (B/S)” is same as that of available-for-sale securities described previously. How about another item, for example, “minimum pension liability adjustment” on FAS No.87? Does it take the same process of “unrealized→realized” that is the premise of recycle method?
If other comprehensive income includes an “substantially another” type of income or the “second” income distinguished from the income described above for which recycle method is applicable, it can be said that it is exactly comprehensive income that includes “heterogeneous” income. Otherwise, we can say that other comprehensive income is no more than “interim and deferred net income” from the view point of net income determination. To begin with, however, can we accept such income, i.e., deferred net income as a concept of income? Can we consider comprehensive income as unitary income or not? What does the term “comprehensive” mean? What and how does it comprehend? These questions should be considered as theoretical subjects not as political ones by examining individual item such as hedges of anticipated transactions or gains/ losses resulting from measuring debts at fair value described in the IASC Discussion Paper “Accounting for Financial Assets and Financial Liabilities” [1997,Ch.7 para4, 3.7].
In summary, at least the following two problems have to be theoretically examined, and a theory which could re-construct these two problems should be developed. Three layers point of view of comprehensive income as shown in Figure 1 could be a useful view point for a resolution of these problems.
Ⅰ)The problem on each principle of income recognition/ measurement corresponding to the arrow ①,②, and ③ respectively as shown in Figure 1.
Ⅱ) The problem on the distinction between income A and B, and between B and C as shown in Figure 1.
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