Question

discuss with examples, the nature of a reclassification adjustment and the arguments for and against allowing reclassification of items to profit or loss

Answer 1

In accounting, the word reclassification is often used to describe moving an amount from one general ledger account to another. For example, if an expense was charged to marketing supplies instead of administrative supplies, the correcting entry might read: To reclassify from marketing supplies to administrative supplies.

Reclassification can also refer to other situations. For example, when a company's long-term note payable becomes due in less than one year, the note will be reclassified to the current liabilities section of the balance sheet. If a company stops using one of its buildings and puts the building up for sale, the building will be reclassified from Property, Plant and Equipment to the Investments section of the balance sheet.

Reclassification adjustments are amounts reclassified to profit or loss in the current period that were recognised in other comprehensive income in the current or previous periods.

Accounting Capital

Home Journal Entries What is a Reclass Entry?
What is a Reclass Entry?
Reclass Entry
Accounting for a business also means being responsible for adjustments and corrections. One such adjustment entry is reclass or reclassification journal entry. The process of transferring an amount from one ledger account to another is termed as reclass entry.

It is most often seen as a transfer journal entry & is a critical part of the final accounts of a business.

Uses of this entry

For correction of a mistake
For reclassification of a long-term asset as a current asset
For reclassification of a long-term liability as a current liability
To change the type & purpose of an asset in the financial statements

Example – Reclass Entry
Though there are quite a few reasons to perform a reclass entry however we will illustrate one of the most common scenarios i.e. correction of a mistake.

The finance department booked payment of Rent expenses for current month using the below journal entry

(Error journal entry)

rent debit by mistake

The above entry was posted to Rent A/C in error as the original payment related to Telephone expenses.

After finding the error a transfer entry was used to reclass the ledger amount of 5,000 in rent account to telephone expenses account.

(Correction reclass entry)

reclass entry in journal

Debit – Debited telephone expenses account to increase expenses by 5,000 in its ledger balance.

Credit – Credited rent account to decrease rent expenses by 5,000 in its ledger balance.

Arguments

Reclassification adjustments are amounts recycled to profit or loss in the current period that were recognised in OCI in the current or previous periods. An example of items recognised in OCI that may be reclassified to profit or loss are foreign currency gains on the disposal of a foreign operation and realised gains or losses on cash flow hedges. Those items that may not be reclassified are changes in a revaluation surplus under IAS 16, Property, Plant and Equipment, and actuarial gains and losses on a defined benefit plan under IAS 19, Employee Benefits.

However, there is a general lack of agreement about which items should be presented in profit or loss and in OCI. The interaction between profit or loss and OCI is unclear, especially the notion of reclassification and when or which OCI items should be reclassified.

A common misunderstanding is that the distinction is based on realised versus unrealised gains. This lack of a consistent basis for determining how items should be presented has led to an inconsistent use of OCI in IFRS. It may be difficult to deal with OCI on a conceptual level since the International Accounting Standards Board (IASB) is finding it difficult to find a sound conceptual basis.

However, there is urgent need for some guidance around this issue.

Opinions vary, but there is a feeling that OCI has become a ‘dumping ground’ for anything controversial because of a lack of clear definition of what should be included in the statement. Many users are thought to ignore OCI, as the changes reported are not caused by the operating flows used for predictive purposes.

Financial performance is not defined in the Conceptual Framework, but could be viewed as reflecting the value the entity has generated in the period and this can be assessed from other elements of the financial statements and not just the statement of comprehensive income. Examples would be the statement of cash flows and disclosures relating to operating segments. The presentation in profit or loss and OCI should allow a user to depict financial performance, including the amount, timing and uncertainty of the entity’s future net cash inflows and how efficiently and effectively the entity’s management has discharged their duties regarding the resources of the entity.

There are several arguments for and against reclassification. If reclassification ceased, there would be no need to define profit or loss, or any other total or subtotal in profit or loss, and any presentation decisions can be left to specific IFRSs. It is argued that reclassification protects the integrity of profit or loss and provides users with relevant information about a transaction that occurred in the period. Additionally, it can improve comparability where IFRS permits similar items to be recognised in either profit or loss or OCI.

Those against reclassification argue that the recycled amounts add to the complexity of financial reporting, may lead to earnings management, and the reclassification adjustments may not meet the definitions of income or expense in the period as the change in the asset or liability may have occurred in a previous period.

The original logic for OCI – it sets-aside income-relevant items that possessed low reliability from contaminating (polluting) the earnings number.

Markets rely on profit or loss and it is widely used. The OCI figure is crucial because it can distort common valuation techniques used by investors, such as the price/earnings ratio. Thus, profit or loss needs to contain all information relevant to investors. Misuse of OCI would undermine the credibility of net income. The use of OCI as a temporary holding for cashflow hedging instruments and foreign currency translation is non-controversial.

However, other treatments such as the policy of IFRS 9 to allow value changes in equity investments to go through OCI, are not accepted universally.

The discussion paper on the Conceptual Framework considers three approaches to profit or loss and reclassification. The first approach prohibits reclassification. The other approaches, the narrow and broad approaches, require or permit reclassification. The narrow approach allows recognition in OCI for bridging items or mismatched remeasurements, while the broad approach has an additional category of ‘transitory measurements’ (for example, remeasurement of a defined benefit obligation), which would allow the IASB greater flexibility. The narrow approach significantly restricts the types of items that would be eligible to be presented in OCI and gives the IASB little discretion when developing or amending IFRSs.

A bridging item arises where the IASB determines that the statement of comprehensive income would communicate more relevant information about financial performance if profit or loss reflected a different measurement basis from that reflected in the statement of financial position. For example, if a debt instrument is measured at fair value in the statement of financial position, but is recognised in profit or loss using amortised cost, then amounts previously reported in OCI should be reclassified into profit or loss on impairment or disposal of the debt instrument.

The IASB argues that this is consistent with the amounts that would be recognised in profit or loss if the debt instrument were to be measured at amortised cost.

A mismatched remeasurement arises where an item of income or expense represents an economic phenomenon so incompletely that presenting that item in profit or loss would provide information that has little relevance in assessing the entity’s financial performance. An example of this is when a derivative is used to hedge a forecast transaction; changes in the fair value of the derivative may arise before the income or expense resulting from the forecast transaction.

The argument is that before the results of the derivative and the hedged item can be matched together, any gains or losses resulting from the remeasurement of the derivative, to the extent that the hedge is effective and qualifies for hedge accounting, should be reported in OCI. Subsequently those gains or losses are reclassified into profit or loss when the forecast transaction affects profit or loss.

This allows users to see the results of the hedging relationship.

The IASB’s preliminary view is that any requirement to present a profit or loss total or subtotal could also result in some items being reclassified. The commonly suggested attributes for differentiation between profit or loss and OCI (realised/unrealised, frequency of occurrence, operating/non-operating, measurement certainty/uncertainty, realisation in the short/long-term or outside management control) are difficult to distil into a set of principles.

Therefore, the IASB is suggesting two broad principles, namely:

Profit or loss provides the primary source of information about the return an entity has made on its economic resources in a period.
To support profit or loss, OCI should only be used if it makes profit or loss more relevant.
The IASB feels that changes in cost-based measures and gains or losses resulting from initial recognition should not be presented in OCI and that the results of transactions, consumption and impairments of assets and fulfilment of liabilities should be recognised in profit or loss in the period in which they occur. As a performance measure, profit or loss is more used, although there are a number of other performance measures derived from the statement of profit or loss and OCI.