Sunday, July 5

Extraordinary Items on Income Statement

What are Extraordinary Items?

Extraordinary items in bookkeeping are revenue announcement events that are both unusual and rare. To put it differently, all these are trades that are unnatural and don’t relate to the principle business activities. They also are not predictable or occur on a regular basis. Historically FASB has required companies to report these transactions separately on the income statement.

In 2015, however, FASB updated its income statement standard number 2015-01 to remove the separate reporting requirements of these items. Although these requirements will not be in place in the future, I think it’s still important to discuss the old way of treating them verses the new standards.

Originally, FASB required that all business transactions be analyzed for two main criteria: unusualness and infrequency. If a deal met both of these criteria, meaning it rarely occurred and was outside the scope of normal business operations, management was required to report these events separately in a different section of the income statement. This decree makes sense because creditors and investors want to see if something affecting the income statement had nothing to do with the business operations.

For example, if the company reported a huge loss from a natural disaster in its income from operations, the net operating income would be artificially low even though its operations might be higher than last year. Thus, reporting it in a separate section of the income statement makes sense. The net operating activities reported are pure, so investors and creditors can see how the core business activities are doing. At the same time, they can see the effects of the extraordinary events on the bottom line.

Financial Statement Disclosure

These events were also required to be disclosed in the company’s financial statement footnotes listing the nature of the events, the extent of the gain or loss, and the income tax ramifications. Management was also required to report and disclose how these items affected the earnings per share calculation.

Let’s look at a few examples.

Example

Assume Paul’s Orange Grove, located in Florida, is gearing up for a great harvest. Then the weather prematurely gets cold and frosts half of the orchard. Is this considered an extraordinary event? Going by the extraordinary item definition, it must meet both criteria. Is this an unusual event? The answer is no. The weather is part of Paul’s business. Going oranges depends on the environment. Is the loss of crops due to frost infrequent? Again, the answer is no. Although devastating frost doesn’t occur each year, it will occur often. Therefore, this reduction isn’t extraordinary.

If Paul lost half of his crop to an earthquake, it might be considered both unusual and infrequent because earthquakes don’t occur in Florida. Here’s a few examples of what was considered outstanding occasions:

  • Expropriation of land with a foreign authorities
  • Condemning land with a national authorities
  • Prohibition of products or services with a fresh law
  • Losses or profits from an unusual and rare act of God or calamity

As you may see, the difficulty that FASB discovered with this idea is that firms seldom have events that fulfill both these standards. Many trades meet among those descriptions, but seldom do events match both. This was causing direction and auditors to devote resources and time to explore every deal with no finding one which fulfilled the essential criteria. To put it differently, it had been a waste of time.

Thus, FASB chose to eliminate the excess test requirements, therefore direction, auditors, and prepares don’t have to waste extra time and resources analyzing transactions. Now companies will simply have to decide whether the events were material to their business practices. These material items are listed separately on the income statement.