Extraordinary Items

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.

ZTE Extraordinary Items

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:

 Materiality

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.read more 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:

 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.

Extraordinary Items

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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.

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.

Extraordinary Items

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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.read more 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.read more 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.read more of the following business assets is in the normal course of business. A company should not treat these as an extraordinary item:

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:

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.read more. 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.

ParticularsAmountAmount
Net SalesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales.read more (Revenue) $ 1,00,000
Less: Cost of goods soldCost Of Goods SoldThe cost of goods sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company.read more ($ 55,000)
Gross ProfitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more $ 45,000
   
Other operating income $ 10,000
Operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more  
a)    Selling & advertisement expenses$ 2,000 
b)    Administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more$ 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 TaxCorporate TaxCorporate tax is a tax levied by the government on the profits earned by a company at a fixed rate each year and is calculated in accordance with specific tax regulations.read more @ 10% ($ 4,600)
Profit from operations after tax (A) $ 41,400
   
Extraordinary items  
a)    Loss on account of a hail storm ($ 25,000)
b)    Gain on account of sale of the 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)
 $ 41.4
Loss per share on account of extraordinary items $ 9.0
Net earnings per share $ 32.4

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.read more.

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.read more. 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.

FASB Update - Extraordinary Items

source: fasb.org

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

 

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