Comprehensive Income Explained | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this final piece on income statements, we’ll explore the concept of comprehensive income in more detail.

As a company generates more income, its assets increase. Part of the net income is paid out to shareholders as dividends, so we’d expect the change in retained earnings to equal net income minus dividends paid.

However, sometimes this isn’t the case. Certain items of revenue and expense, known as other comprehensive income, are excluded from the income statement. To account for the change in retained earnings, we need to consider net income, dividend payouts, and other comprehensive income.

Understanding Other Comprehensive Income

Other comprehensive income consists of items that are not part of the net income calculation but still impact the equity section of the balance sheet. These items are not included in the income statement because they’re either not realized or not part of the company’s core operations. By excluding them from net income, we can focus on the company’s primary earnings activities.

Four Main Types of Other Comprehensive Income

There are four main types of items considered other comprehensive income:

1. Foreign currency translation gains and losses: When a company operates in multiple countries, it must translate its financial statements into its reporting currency. Fluctuations in exchange rates can lead to gains or losses, which are recognized as other comprehensive income.
2. Adjustments for minimum pension liability: Companies with defined benefit pension plans must recognize adjustments to the minimum pension liability. These adjustments reflect changes in the plan’s funded status and are recognized as other comprehensive income.
3. Unrealized gains and losses from cash flow hedging derivatives: When a company uses derivatives to hedge its exposure to changes in cash flows, unrealized gains and losses on these instruments are recognized as other comprehensive income.
4. Unrealized gains and losses from available-for-sale securities: Available-for-sale securities are investments that aren’t expected to be held to maturity or sold in the near term. They’re reported on the balance sheet at fair value, and the unrealized gains and losses don’t appear in the income statement but are reported in stockholders’ equity as a component of other comprehensive income.

Starting in 2018, IFRS no longer allows the available-for-sale classification. However, firms can still choose to treat an equity securities investment as “financial assets measured at fair value through other comprehensive income” at the time of purchase.

Comprehensive Income and Retained Earnings

To calculate comprehensive income, we take the net income, add other comprehensive income, and subtract dividends paid. This gives us the total comprehensive income that accounts for the change in retained earnings for the period.

By understanding comprehensive income, we can better analyze a company’s financial performance and make more informed decisions about its potential as an investment.