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.
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.
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.