Non-Recurring Items – Financial statements are the report card of a company’s performance. They form the backbone upon which business acumen is based. For the outside world, these statements are a window through which one can interpret the health & wealth of a company.
Let us look at the Income statement of Colgate below. In the year 2015, there is a charge for Venezuela accounting change.
source: Colgate 10K 2015
If you notice the item that is highlighted above, we see that the Operating profit decreases significantly due the presence of this item. Also, this item is not present in the other years (2014 and 2013). This item is nothing but Non Recurring item and it can have some serious implications on Financial analysis.
In this article, we look at the following –
- What are Non Recurring Items
- Examples of Non Recurring Items
- Types of Non Recurring Items
- What problem do non recurring items pose to Investors and Analysts?
- Remedies for dealing with Non Recurring Items
What are non recurring items?
Investors use extensively these statements in order to decide whether to invest in a firm or not hence, there has to be a transparent disclosure of revenue & expenses from the firm’s end to ensure that correct information flows to the outside world. But in reality, this doesn’t happens. Most firms report their income & expenses as per GAAP (Generally Accepted Accounting Principles) which is sometimes difficult to interpret for an analyst.
For example, suppose a company purchases a land then GAAP asks the company to report the difference between the Market Price & Purchase price of the land as an Intangible asset and it also asks the firm to report amortization for the intangible assets over a period of time. Such entries are conditional in nature and are related to occurrence of an event ex. purchase of property. Further, such entries gave rise to non-operating revenues and non- operating expenses as these are not tied up with the core business function of a firm. GAAP asks the firms to report a single consolidated number which causes these items to get hidden within the figures thus leading to distortion in valuation.
Examples of Non Recurring Items
Here are some cases when Non-recurring items have affected profit favorably or adversely. The companies referred in these examples are hypothetical.
- XYZ India Bank: The bank reported a drop of 65% in net profit for the September 2015 quarter as a result of higher provisioning done to cover pension, gratuity and loan losses arising as a result of a higher NPA %.
- ABC Pharmaceuticals Ltd: The Company reported a net loss of $1000 million for the March 2014 quarter though its revenue actually grew by 30 %. This loss was attributable to impairment loss, which company took, on the goodwill and other intangible assets of its South African arm.
- XYZ Overseas: The Company reported a growth of 15% in y-o-y revenue but being an import-export player, it got exposed to currency volatility which resulted in a loss of $100 million as the net profit dipped by 20%.
- KKK Group: The Company’s December quarter for 2015 showed a growth of 150% in y-o-y profit. There was a sale of equity stake in one of its subsidiary within the same financial period. If we exclude the gains from equity stake then the net actual profit rose just 20 %.
- Corp PPP Ltd.: The Company was the market leader in the FMCG industry of the US. It reported a profit of 11% in the quarter of December 2015 even after incurring a loss of $150 million as a result of a one-time gain of $400 million that it recorded from property disposal with in the same financial year.
- MMM Associates : The company reported a gain of 8.5% in its revenue y-o-y for 2015 but it suffered loss as a result of expropriation of its property in Ireland by the local government . This brought down its Net income to just 3.75% more than last year’s figure.
Types of Non Recurring Items
There are primarily four types of Non Recurring Items, They are –
- Infrequent or Unusual Items
- Extraordinary Items (Infrequent and Unusual)
- Discontinued Operations
- Changes in Accounting Principles
We will discuss each non recurring item type in detail.
#1 – Infrequent or Unusual Items
These items are either unusual or infrequent but NOT BOTH. These items are reported pre-tax whereas the other three types are reported post-tax.
Infrequent or Unusual Items Examples
- Write-offs or Write Downs of inventory or receivables
- Restructuring cost when acquiring & integrating a new company or implementing changes with in an existing one
- Gain or losses from sale of assets in subsidiaries/affiliates
- Losses incurred from a law suit
- Loss incurred from plant shutdown
Below is an example of Restructuring and asset impairment charges in Intel.
source: Intel Website
#2 – Extraordinary Items (Infrequent and Unusual)
Extra-ordinary Items are both infrequent & unusual and are reported net of income tax.
Extraordinary Items Examples
- Compensation from expropriation of company’s property
- Uninsured losses incurred by the company as a result of natural calamities like earthquake, floods or Tornadoes
- Weather related damage to a property at a place where the occurrence of weather phenomenon is less frequent
- Damage caused due to fire in plant
- Gain or loss from early retirement of debt
- Gain on life insurance/ loss incurred on casualty
- Write-off of intangible assets
International Financial Reporting Standards (IFRS) doesn’t recognizes the concept of extraordinary items at all
Very recently Japan’s Sony Corp estimated $1 billion as earthquake related damages.
#3 – Discontinued Operations
These items are required to be reported in the financial statements if the operation of a part of a firm is either being held for sale or has been already disposed-off. For an item to be qualified as a part of discontinued operations, two basic conditions should be fulfilled -:
- There is no involvement/ influence by the parent company related to financial/ operational matters with in the discontinued component, once the component has been successfully disposed.
- The operations and cash flows from the disposed component will be eliminated from the parents operations.
Impact of discontinued operations appear in the Income Statement as seen below.
Examples include -:
- A Company sells an entire product line with an agreement by the buyer to pay x% of sales as royalty fee. The company will have no involvement/ influence in operational/financial decision making of the spunned-off product line.
- A company sells a product group, with which cash flows where associated and reported at that level, to a buyer.
Note-: if a company sells just a product from its business portfolio to a buyer, it might not qualify as a discontinued operation in case the company is not reporting cash flows at that product level. Also, all contingency liabilities, including interest expenses incurred by the seller in the event of the buyer assuming any debts associated with the disposed component, adjustments related to the selling price and any benefit plans associated with the employees, have to be reported by the selling entity under the discontinued operation segment within the same year.
Below is an example of Discontinued Operations for GE
#4 – Changes in Accounting Principles
Changes in accounting principles happen when there is more than one principle available for applying to a particular financial situation. Changes should be backed by rationale that proves their relevance. These changes have impact not only on the current year financial statements but also on the financial statements of prior periods as they have to be applied retrospectively to ensure uniformity. Retrospective implementation ensures that proper comparison can be done between the financial statements of different periods. Usually, an offsetting amount is adjusted to capture the cumulative effect of such changes.
Changes in Accounting Principles Examples
- Change in inventory management principle from LIFO to FIFO or Specific identification method of inventory valuation or vice versa leads to a significant change in the inventory cost
- Change in the depreciation method from Straight line method to Sum of digits or hours of service method also leads to significant change in the way depreciation amount is reported
In the below mentioned example, we can see that, how a P&L statement should represent Extra-ordinary items, Gain/Loss from Changes in accounting principles and gains from disposal of assets. They all are captured below the line i.e. after the calculation of income from Continued Operations. Such kind of separation helps an analyst to identify the true earnings of an organization.
What problem do non recurring items pose to Investors and Analysts?
- Investors and analysts perform financial statement analysis to estimate the future earnings from current earnings.
- In reality, the profits reported in the statements are noisy i.e. they get distorted by the inclusion of gains & losses from non-operating and non-recurring items. This problem is referred as “the issue of Earnings Quality”.
- Many companies are increasing their Non-operating income as it helps them to hide the losses which they incur from their normal business operations.
- It is the immediate job of an analyst to identify the main sources of revenue and expenses and to also identify the extent to which the company’s earnings depend on them.
- Non –Recurring items are an important source of distortion when it comes to identifying high quality earnings.
- It is suggested that all Non-Operating items (including Non-Recurring items) should be segregated by the analysts so that the resulting earnings represent the true picture of future earnings from regular and continuous business activities.
- This helps in getting a more accurate valuation of a company.
The below mentioned example shows a re-stated Income statement due to Discontinued Operations. Though the Net Income remains unchanged, the re-stated statement allocates the income between Income from Continued Operations and Income from Discontinued Operations.
Also, Investors and analysts’ needs to be always aware of the management’s decision to make accounting changes and adjustments as they drastically impact a companies’ valuation.
- Senior management is well aware of critical decisions such as when to spun-off a business or close a service line and it uses this very advantage in its favor to cover up the quest for future profits by bunching up adjustments and using them at the apt time i.e. when the earnings are expected to be the weakest.
- Also, whenever there is a change in the management, old projects are written-off mainly to show strong changes and improvement for future periods.
- Therefore, it is very important for investors and Security & Exchange board to ask questions regarding the relevance of such changes and sell offs.
- A security analyst should consider all such scenarios while carrying out valuation of the company as they encapsulate hidden motives which are strong enough to distort the valuation figures.
Remedies for dealing with Non Recurring Items
Reporting standards follow different approaches when it comes to displaying the Non-Recurring items. IFRS ignores extraordinary items completely but reports all other types whereas GAAP reports all types of non-recurring items. These items are well explained in the foot notes of financial statements.
Generally, there are three available methods to deal with non-recurring items while performing financial analysis/valuation. They are as follows -:
#1 – Allocate them with in the Single Financial year
This approach talks about reporting a non-recurring item with in the same financial year. Though allocating gains or losses to a single year doesn’t seems to be a right way for handling such items, it is still preferred when dealing with items that have small amount attached to them or they have very little impact on valuation matrices like EBITDA or Net Income.
#2 – Use Straight line spreading (Distributing them historically)
This approach emphasizes on the principal of spreading the non-recurring items over the past accounting periods to estimate the real earning power of the company. The only de-merit that it carries is that it may misrepresent the economies within a financial period
#3 – Exclude them all together
Though it seems to be the easiest of the three approaches, it involves a lot of rationalization and logical thinking by the analyst while deciding which item he/she should exclude. There has to be a proper justification for the exclusion and when he/she does this, there has to be a proper adjustment in the tax to nullify the gain/loss attached with the item. For example –: An early retirement of debt can be excluded from the current year.
A consistent and rational approach would be the one which emphasizes more on the nature of the non-recurring item for deciding which of the three above mentioned methodologies have to be used rather than using one of them on a standalone basis.
It is suggested that -:
- Small items which have a very lesser impact on the Net Income should be accepted with a financial year itself.
- If an item is altogether excluded, proper adjustment should be done while reporting the income tax.
- Items excluded from the single year analysis should be included in a historical statement, which encompasses different accounting periods, using the straight line spreading approach. This averages out their effect just like capitalization averages out the revenue/expenses of a newly acquired asset (PP&E) over its useful life.