In this video, we walk through 5 FAR practice questions teaching about items classified as other comprehensive income (OCI). These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Items Classified as Other Comprehensive Income (OCI)
Other Comprehensive Income (OCI) is an essential component of financial reporting that provides a more comprehensive picture of a company’s overall financial performance. OCI includes revenues, expenses, gains, and losses that are excluded from net income on the income statement. Instead, these items are recorded directly in equity under accumulated other comprehensive income (AOCI). This ensures that these items, which typically have the potential to impact a company’s financial health but are not realized yet, do not distort the company’s net income.
Key Components of OCI
Unrealized Holding Gains and Losses on Available-for-Sale Debt Securities
Available-for-sale (AFS) debt securities are financial instruments that a company does not intend to hold until maturity, nor sell in the near term. The unrealized gains and losses on these securities, due to fluctuations in fair value, are recorded in OCI.
For example, if a company holds AFS debt securities worth $500,000 and their market value increases to $550,000, the $50,000 unrealized gain would be recorded in OCI. When these securities are eventually sold, the gains or losses are reclassified from OCI to net income.
Foreign Currency Translation Adjustments
Companies with international operations often have to consolidate financial statements from foreign subsidiaries that use different currencies. The resulting gains or losses from translating these foreign financial statements into the parent company’s reporting currency are included in OCI.
For instance, if a U.S.-based company owns a subsidiary in Europe, and the Euro strengthens against the U.S. Dollar, the value of the subsidiary’s assets and liabilities, when translated into Dollars, may increase, creating a translation gain recorded in OCI.
Unrealized Gains and Losses on Cash Flow Hedges
Cash flow hedges are derivative instruments used to hedge forecasted transactions, such as future sales or purchases. The effective portion of the gain or loss on the hedging instrument is recorded in OCI and later reclassified into net income in the same period(s) when the hedged transaction affects earnings.
For example, if a company expects to purchase raw materials in six months and hedges this purchase using a derivative contract, any unrealized gains or losses on this hedge are recorded in OCI until the purchase occurs.
Unrealized Gains and Losses from Transfers Between Categories
When a company reclassifies a debt security from held-to-maturity (HTM) to available-for-sale (AFS), the unrealized gains or losses at the time of the transfer are included in OCI.
For example, if a company holds an HTM security with an amortized cost of $100,000, and upon reclassification to AFS, the fair value is $110,000, the $10,000 unrealized gain is recorded in OCI.
Instrument-Specific Credit Risk
For financial liabilities that a company elects to measure at fair value, changes in fair value attributable to the company’s own credit risk are recorded in OCI. This separates the effects of credit risk from the company’s operational results.
For example, if a company has issued bonds and the fair value decreases by $30,000 due to a decrease in the company’s creditworthiness, this $30,000 is included in OCI.
Examples and Application
Consider a multinational corporation, TechSolutions Inc., which has several items contributing to OCI in its financial statements for the year:
- AFS Debt Securities: TechSolutions holds AFS debt securities that appreciated by $100,000. This unrealized gain is recorded in OCI.
- Foreign Subsidiary: TechSolutions has a subsidiary in Japan. Due to exchange rate fluctuations, it records a translation gain of $50,000 in OCI.
- Cash Flow Hedge: The company uses a derivative to hedge against the price volatility of a key component, resulting in an unrealized gain of $30,000 recorded in OCI.
- Reclassified Securities: It reclassified a $1,000,000 HTM security to AFS, with a fair value gain of $40,000 at the time of reclassification, recorded in OCI.
- Credit Risk: The fair value of TechSolutions’ issued bonds decreased by $20,000 due to credit risk, which is also recorded in OCI.
Conclusion
OCI plays a crucial role in providing a comprehensive view of a company’s financial health by capturing items that impact equity but are not part of the regular earnings cycle. These items often represent potential future gains or losses that, if realized, will affect the company’s financial performance. Understanding and accurately reporting OCI ensures transparency and provides stakeholders with a more detailed picture of a company’s overall financial condition.
