Within this section we will further our discussion on the non-recurring components of net income, such as unusual or infrequent items, discontinued operations, extraordinary items, and prior period adjustments.
Unusual or Infrequent Items
Included in this category are items that are either unusual or infrequent in nature but cannot be both.
Examples of unusual or infrequent items:
Gains (or losses) as a result of the disposition of a company's business segment including:
- Plant shutdown costs
- Lease-breaking fees
- Employee-separation costs
Gains (or losses) as a result of the disposition of a company's assets or investments (including investments in subsidiary segments) including:
- Plant shut-down costs
- Lease-breaking fees
- Gains (or losses) as a result of a lawsuit
- Losses of operations due to an earthquake
- Impairments, write-offs, write-downs and restructuring costs
- Integration expenses related to the acquisition of a business
- Gains (or losses) as a result of the disposition of a company's business segment including:
Accounting treatment is usually displayed as pre-tax. That means that they are displayed on the income statement after income from continuing operations gross of tax implication.
Events that are both unusual and infrequent in nature are qualified as extraordinary expenses.
Example of extraordinary items:
- Losses from expropriation of assets
- Gain (or losses) from early retirement of debt
Accounting treatment is usually displayed net of tax. That means that they are displayed on the income statement after income from continuing operations net of its tax implication.
Sometimes management decides to dispose of certain business operations but either has not yet done so or did it in the current year after it had generated income or losses. To be accounted for as a discontinued operation, the business must be physically and operationally distinct from the rest of the firm. Basic definitions:
- Measurement date - The date when the company develops a formal plan for disposing.
- Phaseout period - Time between the measurement date and the actual disposal date
The income or loss from discontinued operations is reported separately, and past income statements must be restated, separating the income or loss from discontinued operations.
On the measurement date, the company will accrue any estimated loss during the phaseout period and estimated loss on the sale of the disposal. Any expected gain on the disposal cannot be reported until after the sale is completed (same rule applies to the sale of a portion of a business segment).
Important: Accounting treatment of income and losses from discontinued operations are reported net of tax after net income from continuing operations.
Accounting changes occur for two reasons:
- As a result of a change in an accounting principle
- As a result of a change in an accounting estimate.
The most common form of a change in accounting principle is the switch from the LIFO inventory accounting method to another method such FIFO or average cost basis.
The most common form of a change in accounting estimates is a change in depreciation method for new assets or change in depreciable lives/salvage values, which is considered a change in accounting estimates and not a change in accounting principle. Note that past income does not need to be restated from the LIFO inventory accounting method to another method such FIFO or average cost basis.
In general, prior years' financial statements do not need to be restated unless it is a change in:
- Inventory accounting methods (LIFO to FIFO)
- Change to or from full-cost method (This is used in oil & gas exploration. The successful-efforts method capitalizes only the costs associated with successful activities while the full-cost method capitalizes all the costs associated with all activities.)
- Change from or to percentage-of-completion method (look at revenue- recognition methods)
- All changes just prior to a company's IPO
Prior Period Adjustments
These adjustments are related to accounting errors. These errors are typically NOT reported in the income statement but are reported in retained earnings. (These can be found in changes in retained earnings.) These errors are disclosed as footnotes explaining the nature of the error and its effect on net income.
InvestingWhen it comes to analyzing a company, successful analysts spend considerable time differentiating between accounting items that are likely to recur going forward from those that most likely will ...
InvestingDirty surplus items can skew net income. Knowing how to account for them will give you a cleaner picture.
InvestingFinancial statements are a picture of a company’s financial health for a given period of time at a given point in time. The statements provide a collection of data about a company’s financial ...
InvestingRather than relying solely on net profit figures to evaluate a company's performance, seasoned investors will often look at gross profit and operating profit as well.
InvestingWe go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
InvestingHow a company accounts for its expenses affects how its net income and cash flow numbers are reported.
InvestingBy using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
InvestingAccounting practices have matured, but there are still plenty of ways that companies can disguise their financial results.