source: ZTE Annual Report
Extraordinary Items – Every business has its routine business on account of which it earns either profit or loss. E.g. XYZ Co. is a manufacturer of automobiles will earn profit (or loss) from sale of cars, trucks, buses, etc. However, now let us assume that XYZ wants to discontinue the car manufacturing business and focus more on heavy automobiles like trucks and buses. It sells the entire car making division to another automobile manufacturer for a very hefty profit. This definitely results in profit and will be reported in XYZ’s financial statements but as an extraordinary item as it is not the normal course of business that XYZ has earned such a huge profit.
Let us have a look at ZTE Annual Report, we note that Net profit Attributable to Shareholders is RMB 2,633 million, however, when we remove the extraordinary items from the Income Statement, the Net Profit gets reduced to RMB 2,072 million.
In this article, we discuss Extraordinary Items in detail –
- What are Extraordinary Items?
- Bifurcating Extraordinary Items
- Presentation of Extraordinary Items (Before January 2015)
- Elimination of Extraordinary Items (After January 2015)
What are Extraordinary Items?
Extraordinary items refer to gains and losses from specific business transactions which are unusual and rare from the normal course of business. In other words, they pertain to transactions which do not form a part of the day-to-day business operations of the company.
Some of the key aspects which define extraordinary items are:
Extraordinary Items – Materiality
Transactions which are above the material limit of an organization will be classified under extraordinary items of the company. Materiality is subjective to the size of balance sheet of the organization and the industry to which the company belongs.
- Example 1: In case of XYZ Co., if it is involved in scrap sale of a business unit in Chicago which has led to a business gain of $ 10,000 will not be material enough to be classified as an extraordinary gain. This is because value of one car will be more than $ 10,000 which is definitely not material keeping in mind that the entire revenue of XYZ Co. is $ 100 billion.
- Example 2: A small time retailer who sells hotdogs outside Central Park earns royalty amounting to $ 5,000 for selling his hotdog recipe to a chain store will classify this transaction as an extraordinary item as it is above the materiality threshold. Why is it material in this case – because the annual profit of the retailer is somewhere around $ 5,000 itself.
To check whether a particular transaction is material for reporting it as an extraordinary item the following three levels of materiality should be checked:
- Particular extraordinary item is material with respect to the total income reported for that given period
- Particular extraordinary item is material with respect to the annual income of the last 4-5 years taken into account
- Particular extraordinary item is material with respect to any other criteria defined by the company policy e.g. a holding company may require its subsidiary companies to report all extraordinary items above a certain threshold.
Extraordinary Items – Rare / Unusual transactions
Extraordinary items will be rare in nature. They are transactions which do not occur on a day-to-day basis. Like we saw in the case of XYZ Co. discontinuing the car manufacturing business is something which does not happen regularly. It will happen once in 5 years or 10 years or at times never in the lifetime of the company.
Important point to understand here is that not all rare / unusual / non-recurring transactions are necessarily defined as extraordinary items. There can be transactions which are non-recurring but at the same time are not extraordinary.
- Example 1: XYZ Co. feels that the current capacity of manufacturing buses is limited and there is a lot of scope in the market for increasing revenue. Keeping this in mind, the management has approved to go ahead with the investing in a new plant for increasing the production capacity. This is definitely a non-recurring transaction; however, the same can be taken as increase in capital assets rather than classifying it as an extraordinary loss.
- Example 2: Continuing with the very first example of XYZ Co. where they intend to discontinue their car manufacturing business is a non-recurring transaction and qualifies as an extraordinary gain.
Bifurcating Extraordinary Items
Extraordinary items can be bifurcated into extraordinary gains and extraordinary losses. Needless to say losses have a negative impact on the profit of the company whereas extraordinary gains have a positive impact on the profit of the company.
Example of extraordinary gains
- Gain on account of sale of discontinued business segments
- Gain from a recent announcement from the government announcing previous subsidies to be sanctioned now
Examples of extraordinary losses
- Loss on account of uncontrollable natural calamities such as earthquakes, floods, hailstorms, etc.
- Loss on sale of discontinued business segments
- Loss on account of losing a legal case which has led to huge tax penalties
- Loss on account of a long workers strike which has disrupted business for more than a month
The above examples are generic in nature and can vary on a case to case basis. For instance, loss on account of flood cannot be claimed as extraordinary losses in case of businesses in areas which are already declared as flood prone areas. This because it is assumed that business is aware of the climatic conditions in the area and are still willing to take the risk of doing business in that area. Hence, this is a part of the business risk which the organization must have already taken into account.
Another example which we can consider is the case of a private equity firm which has its core business to invest in startups. In this case, gain or loss from selling of business is normal and not irregular or rare. Therefore, it cannot claim gain on account of selling long-term investments as extraordinary gains.
Also, important point is there is confusion with regards to treating write-off / write back of various assets as extraordinary loss. In this context, write-off of the following business assets is in the normal course of business and should not be treated as an extraordinary item:
- Accounts receivable
- Amortization of intangible assets
- Loss or gain on account of foreign currency exchange and other transactions
- Sale of fixed assets
This is because write-off / write down of the above current and fixed assets are considered very normal for any given business and the following explanation should suffice for not treating it is an extraordinary item:
- Inventory lying in the warehouse will get old and obsolete. This happens with almost all businesses and is part of the operational loss only.
- A certain part of accounts receivable is expected to turn into bad debts in the normal course of business and such a loss is operational in nature.
- Intangible assets should be amortized on a yearly basis just the way tangible fixed assets are depreciated on a yearly basis.
- Foreign currency will fluctuate on a daily basis and if there is a business requirement to enter into foreign currency transactions, the gain or loss from these transactions is considered to be normal.
- Buying and selling of fixed assets is an essential part of the business. Even if these transactions are rare, they are required from the operational point of view. Any profit earned or loss incurred from sale of fixed assets should be treated as part of operational income/expense only
Presentation of Extraordinary Items (Before January 2015)
All extraordinary items are to be presented separately in the financial statements. Presented it separately means that the gain or loss from extraordinary items should be segregated from the profit/loss from ordinary operations and should be shown as a separate line item in the income statement after taking the tax effect into consideration.
The company should also disclose the applicable taxes on these extraordinary items separately and along with it, they should also disclose earnings per share for extraordinary items.
The following is the Income Statement of XYZ Co. to show the presence of extraordinary items:
|Income Statement of XYZ Co.|
|Net Sales (Revenue)||$ 1,00,000|
|Less: Cost of goods sold||($ 55,000)|
|Gross Profit||$ 45,000|
|Other operating income||$ 10,000|
|a) Selling & advertisement expenses||$ 2,000|
|b) Administrative expenses||$ 2,500|
|c) Auditor’s remuneration||$ 2,000|
|d) Other expenses||$ 1,000||($ 7,500)|
|Operating income||$ 47,500|
|Other income (classified as non-operating such as interest income)||$ 500|
|Other expense (classified as non-operating such as financial cost)||($ 2,000)|
|Net income / (loss) from operations||$ 46,000|
|Less: Corporate Tax @ 10%||($ 4,600)|
|Profit from operations after tax (A)||$ 41,400|
|a) Loss on account of hail storm||($ 25,000)|
|b) Gain on account of sale of business segment||$ 15,000|
|Loss from extraordinary items||($ 10,000)|
|Savings on tax @ 10%||$ 1,000|
|Net loss from extraordinary items (B)||($ 9,000)|
|Net Income||$ 32,400|
|Earnings per share from operating income
(Assumption – company has issued 1000 equity shares)
|Loss per share on account of extraordinary items||$ 9.0|
|Net earnings per share||$ 32.4|
Why is the above presentation necessary? This is in order to give a true picture to the various users of the financial statement.
Elimination of Extraordinary Items (After January 2015)
In January 2015, FASB issued an update to Extraordinary items eliminating the need to provide Extraordinary Items in the income statement. Eliminating the concept of extraordinary items will save time and reduce costs for preparers because they will not have to assess whether a particular event or transaction event is extraordinary.
It was primary argued that users find information about unusual or infrequent events and transactions useful, however, they do not find the extraordinary item classification and presentation necessary to identify those events and transactions. Others thought that it is extremely rare in current practice for a transaction or event to meet the requirements to be presented as an extraordinary item.
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