To get ahead as a financial analyst, you must become very skilled at using past information to make a reasonably accurate prediction of the future. When it comes to analyzing a company, successful analysts spend considerable time trying to differentiate between accounting items that are likely to recur going forward from those that most likely will not. A key part of this analysis is to understand items that qualify as extraordinary items or nonrecurring items. A savvy analyst will separate these items from recurring ones, and will stand a much better chance at predicting the future than one who simply looks at the bottom-line earnings companies must report in their financial statements.
The term "extraordinary item" refers to gains or losses in a company's financial statements that are infrequent and unusual. Basically, an item is deemed extraordinary if it is not part of a company’s ordinary, day-to-day operations. More detailed explanations of these types of items will be included in the notes to the financial statements in company annual reports or financial filings with the Securities & Exchange Commission (SEC). Another key stipulation is that the item is material, meaning that it has a significant impact on a firm’s profitability and should therefore be broken out separately.
Examples of Extraordinary Items
Accountants spend considerable time determining whether an item should be qualified as extraordinary. FASB statement No.145 helps stipulate the accounting charges that can rightfully be considered extraordinary. Again, the unusual and infrequent natures are primary considerations. Specific examples can include charges from discontinued operations, such as a write-down that occurred when a company decided to shut down or sell an operation. The disposal of a plant or major piece of equipment could easily qualify. Gains or losses due to accounting charges are also fair game, as are charges to write down the value of goodwill.
Just as many examples of accounting items qualify as extraordinary, many others do not qualify. The FASB specifically states that most types of write-offs, write-downs, gains or losses should not be treated as extraordinary items. This could include a wide array of items, such as abandoning property, accruals on long-term contracts, disposing of a component of an entity, effects of a strike, foreign currency exchange, intangible assets, inventories, receivables and adjustments on long-term contracts.
A nonrecurring item refers to an entry that appears on a company's financial statements that is unlikely to happen again. It represents a one-time expense involving an unpredictable event and is not part of a firm’s normal, day-to-day operations. The terms nonrecurring item and nonrecurring charge can be used interchangeably and refer to a one-time charge from an unpredictable event that is not expected to persist.
Just like an extraordinary item, details on nonrecurring items can be found in the footnotes of the income statement. They can also be located in a section of the financial statements known as Management Discussion and Analysis, which can be found following a company’s financial statements.
Examples of Nonrecurring Items
As you might guess, there are many examples of nonrecurring items. These can include litigation charges, charges related to letting workers go, repair costs from a fire, tornado or other natural disaster, and restructuring charges to realign a business or operating unit. Finally, emergency costs to repair or replace worn down or broken equipment can also qualify as nonrecurring.
The Differences Between Extraordinary and Nonrecurring Items
Making a proper distinction between an extraordinary item and a nonrecurring one is not the most straightforward exercise. Most financial literature tends to lump one-time items together and focus on separating them from those that are likely to recur in the future. In many cases, this is fine because the most important exercise in analyzing a firm’s financial statements is separating recurring from nonrecurring items.
However, there are differences to note. For instance, nonrecurring items can be recorded under operating expenses in the net income statement. In contrast, extraordinary items are most commonly listed after the bottom line net income figure. They are also usually provided after taxes.
Another important item to note is that International Financial Reporting Standards (IFRS) does not recognize the concept of an extraordinary item. U.S. GAAP makes more of a distinction, such as with the extraordinary item discussion above that covered the unusual and infrequent differences. In this respect, a nonrecurring item might qualify as an unusual or infrequent item, but not both.
As noted above, a successful financial analyst will be very skilled at adjusting a company’s reported net income figure. This will include backing out items that are one-time in nature and not likely to persist. Making this distinction will help him or her get a much clearer idea about a firm’s financial health and whether it is likely to grow profits going forward.