A tale of two income statements - why investors should scrutinise OCI

THE OCI STATEMENT, which sits alongside the income statement as part of the comprehensive income statement, is comprised of available for sale (AFS) re-measurements, effective cash flow hedge derivatives re-measurements, pension obligation re-measurements and foreign currency translation gains or losses. These gains or losses can help inform readers of financial statements about the overall change in the book value of equity; they are part of the overall profile of wealth creating activities and several studies have shown that they have economic information content. 

Nevertheless, many investors typically only monitor and include income statement line items in their valuation models and concurrently ignore OCI statement line items due to their assumption that these line items are transitory and ‘noisy’ in nature and also in part due to their predominant focus on mainly analyzing the operating activities of reporting companies.

Notwithstanding this current state of affairs, a recent CFA Institute publication makes the case for greater investor scrutiny of OCI line items. This publication specifically focuses on the economic relevance of AFS and cash flow hedge re-measurements of bank financial institutions.

Relevance of OCI for financial institutions

Banks hold AFS securities as part of their liquidity buffers and for the purposes of structurally hedging fixed-rate liabilities. AFS holdings can be material for individual banks- for instance they comprised 15% of HSBC’s and 17% of French bank-Credit Agricole’s total assets for the year ended 2013. The re-measurements of AFS securities can be material too- for instance, in 2008 Belgian bank Dexia’s book value of equity was decimated in large part due to the significant AFS unrealised losses (€11.1bn) which occurred during that year at the onset of the financial crisis. Furthermore, recent research shows that AFS unrealized gains or losses can help to predict total return of fixed income securities.

Effects of interest rate changes on P/B: An important analytical consideration is how the likely reversal of low interest rates as a result of the prevailing accommodative monetary policy will impact the carrying values of interest rate risk-sensitive financial instruments (e.g., debt instruments) and how this in turn could affect the net asset values and Price to Book ratios of banks. Similarly, the reduced credit risk premium on euro-periphery sovereign debt instruments is likely to impact on net asset values of banks.

Effect of AFS re-measurements on regulatory vapital: Under Basel III requirements, AFS securities re-measurements will impact the regulatory capital of UK banks to a greater extent than they have in the past. Prudential regulators, under Basel II, allowed banks to strip out AFS re-measurements when determining regulatory capital. Basel III eliminates the prudential filter and therefore AFS unrealised gains or losses will influence regulatory capital. That said, unlike the UK, many EU jurisdictions (e.g. Italy) have decided to still apply the prudential filter and therefore for banks in these countries, AFS unrealizsd gains or losses will still not impact regulatory capital. IFRS 9 requirements that will be effective from 2018 are unlikely to neuter the impact of re-measurements of securities on regulatory capital in countries that will strictly follow Basel III. Under IFRS 9, most currently classified AFS securities will likely be reported under the fair value through OCI category.

Relevance for insurance companies valuation

A Columbia University research paper finds that when applying relative valuation models (i.e. valuation based on multiples such as P/B or P/E) for insurance companies- valuation models that are based on P/B multiples where the accumulated unrealized OCI gains or losses (i.e. AOCI) is included in the book value of equity tend to have better predictive power than those that are only based on earnings based multiples or those where the book value applied in the P/B ratio excludes AOCI. 

Relevance of OCI for non-financial institutions

The CFA Institute study points to the economic relevance of AFS and cash flow re-measurements. However, other OCI line items (pension re-measurements and foreign currency translation adjustments) can also have economic information content for both financial and non-financial institutions. IASB chair Hans Hoogervorst made a speech in Japan last year pointing to the perils of investors who ignored pension re-measurements reported in OCI while analysing the US auto-sector.

Similarly, it is worth tracking foreign currency translation gains or losses, even though these may be seen as reflecting accounting rather than real economic profit or losses. A UK multinational with foreign subsidiaries and foreign currency denominated profit and net assets, will report translation losses should the GBP appreciate and such translation adjustments can be a leading indicator of future period changes to the underlying profitability and economic value of the foreign subsidiary.

In sum, further to focusing on operating activities reported on the income statement, investors should pay attention to OCI line items, as these have economic information content that provide useful insights across the full spectrum of business activities.

Vincent Papa is a director of financial reporting policy at CFA Institute