What are Extraordinary Items?
Extraordinary Items refers to those events which are considered to be unusual by the company as they are infrequent in nature and the gains or losses arising out of these items are disclosed separately in the financial statement of the company during the period in which such item came into the existence.
Let us have a look at the 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.
Features of 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 that do not form a part of the day-to-day business operations of the company.
Some of the critical aspects are:
Transactions that are 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 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 a 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 (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. Like 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 10 years or, at times, never in the lifetime of the company.
The vital point to understand here 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 to go ahead with investing in a new plant for increasing production capacity. It is a non-recurring transaction; however, the same can be taken an 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 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.
Types of Extraordinary Items
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.
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 as flood-prone areas. It is due to the assumption 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 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 to invest in startups. In this case, gain or loss from the selling of a business is normal and not irregular or rare. Therefore, it cannot claim gain on account of selling long-term investments as extraordinary gains.
Also, an important point is there is confusion with regards to treating write-off/write back of various assets as an extraordinary 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 item:
- 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 is an extraordinary item:
- Inventory lying in the warehouse will get old and obsolete. It happens with almost all businesses and is part of the operational loss only.
- A certain part of accounts receivable expect 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 the way 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 be treated as part of operational income/expense only.
Presentation (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.. Present 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 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 in order 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 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 Video
This article has been a guide to what are Extraordinary Items and its meaning. Here we discuss features and types of extraordinary items with detailed explanations. You may learn more about financing from the following articles –