There are generally accepted accounting principles (GAAP) and rules for the preparation of a company's financial reporting. Nevertheless, the presentation of a company's financial position, as portrayed in its financial statements, is influenced in many instances by management estimates and judgments.

Financial accounting is not an exact science. In the best of circumstances, management is scrupulously honest and candid, while outside auditors are demanding, strict and uncompromising. Even in this best-case scenario, the opportunity exists for selective interpretations of financial accounting principles by company management. Some companies abuse this latitude, but most do not.

Nevertheless, among others, there is one financial reporting practice that needs to be watched carefully by investors: the treatment of special, one-time items in the income statement. In this article, we'll take you on a tour of one-time itemizations and show you what to watch out for.

SEE: Understanding The Income Statement

A Word of Caution
Discussions of corporate management's behavior as it relates to a company's financial accounting and reporting often contain a considerable amount of negative commentary by financial commentators.

The subject matter selected for review in this article comes under particularly harsh scrutiny. In many instances, management is demonized and accused of deliberate deception and unsavory motives, which works against the interests of the company's shareholders.

Therefore, while recognizing that there are times when management's financial reporting practices can and should be questioned, one-time charges in the income statement can be entirely legitimate. The point here is that, whatever the underlying circumstances, the impact on a company's earnings and financial position needs to be fully understood by investors.

Special, One-Time Items in the Income Statement
A special, one-time item, as the term implies, is supposed to be just that - a rare, infrequent event, which financial analysts separate out of the income statement in order to avoid distorting the "regular" earnings reported by a company.

An income statement has four levels of profitability: gross profit, operating profit, pre-tax income and net income. Investors need to be able to make multi-year comparisons (five to 10 years) of a company's profit margins (level of profitability/net sales = % margin) to discern the investment quality inherent in these numbers. If so-called one-time charges occur during any of the years in the period reviewed, they will distort a reliable comparative analysis.

These special items carry various account captions in the income statement and cover different types of events:

  • Extraordinary, unusual, special or non-recurring expenses or charges generally cover such things as material storm damage and adverse legal, regulatory or tax rulings. In addition, changes in accounting principles, over which a company has no control, can bring about income adjustments. While we generally think of these items in the negative sense, as charges to income, they can also be positive, as in a favorable tax ruling, unusual investment gain or an addition to income.
  • Restructuring charges have a negative impact on income and are usually separated out in the income statement. They reflect the costs related to addressing significant corporate operating and/or debt problems.
  • Discontinued operations reveal earnings that are not, or will no longer be, part of a company's operations. They may represent significant assets and/or operations that have been, or are intended to be sold or otherwise disposed of by a company.

The terms "write-down" (reducing the value of an asset) and "write-off" (charging an asset amount to expense or loss) involve relatively small monetary values and are generally considered a part of the ordinary operations of a company.

SEE: Can You Count On Goodwill?

Why Special, One-Time Items Are a Concern for Investors
The simple answer here is that under normal circumstances, these special items can be taken in stride. All the items mentioned above reflect circumstances that are simply a part of corporate life. Let's assume that a company's special items are entirely legitimate, i.e., that management is not practicing any kind of manipulative accounting shenanigans. These events, at the very least, complicate the life of an investor trying to get a clear, true picture of a company's financials.

For example, it is not that unusual to be looking at a company's income statement covering its last three fiscal years and see a different special item in each of the three years. To illustrate this situation, consider a 1995 annual report from Company A. In 1993, the company recorded a material charge for discontinued operations amounting to 75%, an extraordinary gain from the elimination of debt amounting to 103%, and a gain amounting to 25% from the cumulative effect of a change in accounting principle. Things improved in 1994 and 1995 - the former year had only two and the latter year just one special item, respectively.

This rather extreme example of one-time items - not to mention trying to sort out a reliable earnings record - would be a "mission impossible!" The impact of special items on corporate financial reporting is one of the reasons many financial analysts prefer to work with operating income numbers to evaluate a company's earnings, thereby eliminating the distortion of special items.

SEE: Zooming In On Net Operating Income

Since around 2005, many investment professionals have become increasingly concerned about the practice of companies taking so-called "big-bath" charges (extraordinary losses) with such frequency that they are no longer extraordinary but rather commonplace. In this regard, Eastman Kodak, once a prominent blue-chip company, had a run of six major restructurings in a seven-year period during the '90s. A Morningstar stock report on Kodak contained this comment, "Kodak's continual use of one-time charges...results in a confusing [income statement] reporting format." In January of 2012, Kodak filed for Chapter 11 bankruptcy protection.

The Bottom Line
Obviously, a pattern of material, multi-year charge-offs is a warning sign that a company is distorting its earnings performance and that investors should question whether the underlying numbers have any value. Companies showing this type of financial reporting should be avoided, or at the very least, be looked at with a great deal of caution.

Related Articles
  1. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
  2. Investing

    Don't Freak Out Over Black Swans; Be Prepared

    Could 2016 be a big year for black swans? Who knows? Here's what black swans are, how they can devastate the unprepared, and how the prepared can emerge unscathed.
  3. Stock Analysis

    Analyzing Sirius XM's Return on Equity (ROE) (SIRI)

    Learn more about the Sirius XM's overall 2015 performance, return on equity performance and future predictions for the company's ROE in 2016 and beyond.
  4. Stock Analysis

    Will Virtusa Corporation's Stock Keep Chugging in 2016? (VRTU)

    Read a thorough review and analysis of Virtusa Corporation's stock looking to project how well the stock is likely to perform for investors in 2016.
  5. Stock Analysis

    Analyzing Porter's Five Forces on JPMorgan Chase (JPM)

    Examine the major money-center bank holding firm, JPMorgan Chase & Company, from the perspective of Porter's five forces model for industry analysis.
  6. Stock Analysis

    Analyzing Dish Network's Return on Equity (ROE) (DISH, TWC)

    Analyze Dish Network's return on equity (ROE), understand why it has vacillated so greatly in recent years and learn what factors are influencing it.
  7. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  8. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  9. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  10. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
RELATED FAQS
  1. When does a growth stock turn into a value opportunity?

    A growth stock turns into a value opportunity when it trades at a reasonable multiple of the company's earnings per share ... Read Full Answer >>
  2. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  3. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  4. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  5. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  6. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center