Financial Reporting and Analysis II
Reading 21. Understanding Income Statements
Learning Outcome Statements
f. describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, extraordinary items, unusual or infrequent items) and changes in accounting standards;
g. distinguish between the operating and non-operating components of the income statement;
CFA Curriculum, 2020, Volume 3
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Subject 6. Non-Recurring Items and Non-Operating Items
Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring," especially those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring," regardless of their accounting labels.
There are four types of non-recurring items in an income statement.
1. Discontinued operations
Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized.
- Subsidiaries and investees also qualify as separate components.
- Disposal of a portion of a business component does not qualify as discontinued operations. Instead, this is recorded as an unusual or infrequent item.
2. Extraordinary items
Extraordinary items are BOTH unusual in nature AND infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax.
Common examples are:
- Expropriations by foreign governments.
- Uninsured losses from earthquakes, eruptions, and tornadoes.
Starting 2016, businesses and other organizations should report transactions that are either unusual or rare on the income statement or disclose them in their financial statement footnotes. There is no such concept of "extraordinary items".
The International Financial Reporting Standards (IFRS) do not include extraordinary items in their accounting practices.
3. Unusual or infrequent items
These are either unusual in nature OR infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations.
Common examples are:
- Gains or losses from disposal of a portion of a business segment.
- Gains or losses from sales of assets or investments in affiliates or subsidiaries.
- Provisions for environmental remediation.
- Impairment, write-offs, write-downs, and restructuring costs (such as those costs related to the integration of acquired companies).
4. Changes in accounting principles
Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on an after-tax basis. They are typically reported through retrospective application, which means that the financial statements for all fiscal years shown in a company's financial report are presented as if the newly adopted accounting principle had been used throughout the entire period.
Changes in accounting estimates, such as changes in asset lives or salvage value when recording depreciation expenses, are not considered changes in accounting principles. The impact of such a change is only prospective, and no retroactive or cumulative effects are recognized.
A change from an incorrect to an acceptable accounting method is treated as an error and its impact is reported as a prior period adjustment.
Non-operating Items: Investing and Financing Activities
Non-operating items are reported separately from operating items. For example, if a non-financial service company invests in equity or debt securities issued by another company, any interest, dividends, or profits from sales of these securities will be shown as non-operating income.
Non-recurring items should be scrutinized to assess whether they are truly "non-recurring." For example, gains or losses from the sale of fixed assets are classified as unusual or infrequent items. However, for a car rental company that retires part of its fleet of cars annually, such gains or losses are rather recurring in nature. Some non-recurring charges are, in fact, prior period expenses taken too late or future expenses taken too early. For example, asset write-downs may indicate that prior period depreciation or amortization changes were insufficient. Therefore, completely ignoring such non-recurring items in financial analysis may result in an overestimation of a company's earning trend.
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change from incorrect to correct accounting treatment is treated as prio period adjustment. and treated as an error.
does that mean even the correction is made to the accouting method, is it still consider an error?
I - Income from continuing
D - Discontinued
E - Extraordinary
A - Accounting changes
The accounting change doesn't sound right. Retrospective adjustments due to change in accounting policy requires restatement, which means an adjustment to retained earnings (equity account) and has nothing to do with current period income. It will show up in the statement of equity but should not be part of the income statement. I'm a CPA by the way.
In January 2015, a new accounting standards update eliminated the idea of extraordinary items. While companies no longer must entitle events and their effects as extraordinary, they still have to disclose infrequent and unusual events on the income statement and their effect before income taxes. Also, GAAP allows companies to give these events more specific names, such as "Effects From Fire at Production Facility."