What Are Extraordinary Items?
Extraordinary Items refer to those events considered unusual by the company as they are infrequent. The gains or losses arising from these items are disclosed separately in the company’s financial statement during the period such items came into existence.
Such items may affect the financial performance of the business in a significant manner. However, they may be treated in the statements differently, and used depending on the type of accounting standards that are followed. They are highly unusual or totally unrelated to the normal business operations.
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Extraordinary Items Explained
The extraordinary items are a financial concept used in Generally Accepted Accounting Principles(GAAP) in the US before issuing the Accounting Standards Update(ASU) No- 2015-1. This rule came into effect after December 15, 2015 and it abolished this concept from GAAP.
Due to the above reason, the corporates are no longer required to show or report the items in their financial statements. However in extraordinary items accounting, some items that were previously included under the extraordinary item category and reported in the financial statements are losses due to any kind of natural disaster or calamity, losses due to any political problems in the country, asset expropriation by the government of the country, etc.
Let us have a look at the ZTE Annual Report. We note that the 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.
Thus, from the above explanation, we note that since this financial concept is no longer in practice in the industry, the companies do not include them in the financial statements as extraordinary item. Instead, asper the current standards of accounting, any significant event or transaction is included in the statements as a normal income or loss incurred from continuing operations. The extraordinary items accounting are seperately reported so that the users of the financial statements can get clarity and all transactions remain transparent.
The income statement 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 that do not form a part of the company’s day-to-day business operations.
Some of the critical aspects are:
Transactions above the material limit of an organization will classify under extraordinary items of the company. Materiality is subjective to the size of the balance sheetThe Size Of The Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company. and the industry to which the company belongs.
- Example 1: In the case of XYZ Co., if it is involved in the 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. It is because the value of one car will be more than $ 10,000, which is 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 the transaction is material for reporting it as an extraordinary item, the following three levels of materiality should be checked:
- A particular income statement extraordinary items concerns the total income reported for that period.
- A particular extraordinary item is material concerning the annual income of the last 4-5 years taken into account.
- A particular extraordinary item is material concerning any other criteria defined by the company policy, e.g., a holding company (parent company)Holding Company (parent Company)A holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. may require its subsidiary companies to report all extraordinary items above a certain threshold.
Rare / Unusual transactions
They will be rare in nature. They are transactions that do not occur on a day-to-day basis. As we saw in the case of XYZ Co., discontinuing the car manufacturing business is something that does not happen regularly. It will happen once in 5 years or ten years or, at times, never in the company’s lifetime.
The vital point is that not all rare/unusual/non-recurring transactions are necessarily defined as extraordinary items. There can be non-recurring transactions 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 investing in a new plant to increase production capacity. It is a non-recurring transaction; however, the same can be taken as an increase in capital assets rather than classified as a tremendous 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 transactionNon-recurring TransactionNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off. and qualifies as an extraordinary gain.
Extraordinary Items Video
They can be bifurcated into extraordinary gains and extraordinary losses. Losses harm the profit of the company, whereas extraordinary gains have a positive impact on the profit of the company.
It is essential to understand the fact that whether the event or the transaction falls under the category of list of extraordinary items or not is subjective. It requires a thorough and careful analysis of the event and the circumstances that lead to it. Since, as mentioned earlier, the rule of reporting has changed and now these items are shown as a regular financial reporting process, additional information is needed to let the users know and catagorize them as extraordinary or not.
Some examples of both gains and losses due to such events will help in understanding the concept. Let us go through list of extraordinary items as given below:
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 colossal tax penalties
- Loss on account of a long workers strike which has disrupted business for more than a month
The above examples are generic and can vary on a case-to-case basis. For instance, loss on account of the flood cannot be claimed as an extraordinary loss in the case of businesses in areas declared flood-prone areas. It is due to the assumption that businesses are 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 riskThe Business RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand. which the organization must have already taken into account.
Another example that we can consider is the case of a private equity firmPrivate Equity FirmPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP. that has its core business investing in startups. In this case, gain or loss from selling a business is normal and not irregular or rare. Therefore, it cannot claim gain because of selling long-term investments as extraordinary gains.
Also, the important point is that there is confusion regarding treating the write-off/write-back of various assets as a great loss. In this context, the write-offWrite-offWrite off is the reduction in the value of the assets that were present in the books of accounts of the company on a particular period of time and are recorded as the accounting expense against the payment not received or the losses on the assets. of the following business assets is in the normal course of business. A company should not treat these as an extraordinary items:
- Accounts receivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year.
- Amortization of intangible assetsAmortization Of Intangible AssetsAmortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.
- Loss or gain on account of foreign currency exchange and other transactions
- Sale of fixed assets
It is because write-off/write-down of the these current and fixed assets are considered very normal for any given business, and the following explanation should suffice for not treating it as an extraordinary item:
- Inventory lying in the warehouse will get old and obsolete. It happens with almost all businesses and is only part of operational loss.
- A certain part of accounts receivable expects to turn into bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation. in the normal course of business, and it is an operational loss.
- Intangible assets should be amortized yearly, just as tangible fixed assets depreciate yearly.
- Foreign currency will fluctuate daily. 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, businesses require them from the operational point of view. Any profit earned or loss incurred from the sale of fixed assets should only be treated as part of operational income/expense.
It is necessary to clearly understand the method of accounting of these type of assets as extraordinary items in financial statements. There has been a significant change in this field since January 2015, as detailed below. Let us study the same.
(Before January 2015)
All extraordinary items are to be presented separately in the financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.. Presenting it separately means that the gain or loss from extraordinary items should be segregated from the profit/loss from ordinary operations and shown as a separate line item in the income statement after considering the tax effect.
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 such items.
The following is the Income Statement of XYZ Co. to show the presence of extraordinary items:
Income Statement of XYZ Co.
Why is the above presentation necessary? It is to give a true picture to the various users of the financial statementUsers Of The Financial StatementFinancial statements prepared by the Companies are used by different categories of individuals and corporates on the basis of their relevancy to the respective parties. The most common users to the financial statements are Management of the Company, Investors, Customers, Competitors, Government and Government Agencies, Employees, Investment Analysts, Lenders, Rating Agency and Suppliers..
Elimination (After January 2015)
In January 2015, FASB issued an update to Extraordinary items eliminating the need to provide Extraordinary Items in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.. Eliminating this concept of extraordinary items in financial statements 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 primarily 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.
Extraordinary Items Vs Exceptional Items
Both the above terms are used to describe some special events or transactions in the company operations that are mentioned in the financial statements, which affect the performance and profitability. However, the treatment of both the concepts has some differences as per the accounting standards followed in the organization.
- The former refers to transactions and events that occur in an unusual manner or very less frequent, whereas the latter refers to transactions that may be infrequent but not extraordinary. They are within the scope of the business.
- The former refers to transaction that are unusual in nature, which is not the case with the latter. Exceptional items arise from ordinary business activities or core operations.
- Some examples of the former include loss due to natural calamity or sale of business assets by the government, etc but the examples of the latter include cost or restructuring or sale of non-core assets, writing down of some company assets, etc.
It is to be noted that both are disclosed in the financial statements for users to be aware of the same.
This article has been a guide to what are Extraordinary Items. We explain them with examples, accounting, differences with exceptional items, types & features. You may learn more about financing from the following articles –
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