What are Non-Recurring Items?
Non-recurring items are those sets of entries that are found in the income statement that are unusual and are not expected during the regular business operations; examples of which include gains or loss from the sale of assets, impairment costs, restructuring costs, and losses in lawsuits, inventory write-off, etc.
Let us look at the Income statement of Colgate above. In 2015, there was a charge for Venezuela’s accounting change.
If you notice the item highlighted above, we see that the Operating profit decreases significantly due to the presence of this item. Also, this item is not present in the other years (2014 and 2013). This item is nothing but a Non Recurring item, and it can have severe implications on Financial analysis.
Table of contents
- What are Non-Recurring Items?
- Examples of Non-Recurring Items
- Types of Non-Recurring Items
- #1 – Infrequent or Unusual Items
- #2 – Extraordinary Items (Infrequent and Unusual)
- #3 – Discontinued Operations
- #4 – Changes in Accounting Principles
- What problem do nonrecurring items pose to Investors and Analysts?
- Remedies for dealing with Non-Recurring Items
- Non Recurring Items in Financial Statements Video
- Recommended Articles
Examples of Non-Recurring Items
Here are some cases when Non-recurring items have affected profit favorably or adversely. The companies referred to in these examples are hypothetical.
- XYZ India Bank: The bank reported a drop of 65% in net profit for the September 2015 quarter due to higher provisioning to cover pension, gratuity, and loan losses arising from a higher NPA %.
- ABC Pharmaceuticals Ltd: The Company reported a net lossA Net LossNet loss or net operating loss refers to the excess of the expenses incurred over the income generated in a given accounting period. It is evaluated as the difference between revenues and expenses and recorded as a liability in the balance sheet. of $1000 million for the March 2014 quarter though its revenue grew by 30 %. This loss was attributable to impairment loss, in which the company took on its South African arm’s goodwill and other intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. 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 an equity stake in one of its subsidiaries within the same period. If we exclude the gains from the equity stake, the actual net profit rose just 20 %.
- Corp PPP Ltd.: The Company was the market leader in the FMCGFMCGFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc. industry in the US. It reported a profit of 11% in the quarter of December 2015, even after incurring a loss of $150 million due to a one-time gain of $400 million that it recorded from property disposal within 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 a loss as a result of the expropriation of its property in Ireland by the local government. It brought down its Net income to just 3.75% more than last year’s figure.
Video Explanation of Non-Recurring Items in Financial Statements
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
The first type of non-recurring item is 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 DownsWrite DownsWhen the carrying value (purchase price – accumulated depreciation) of an asset exceeds its fair value, it is referred to as a write down. of inventory or receivables
- Restructuring costsRestructuring CostRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements. when acquiring & integrating a new company or implementing changes within an existing one
- Gain or losses from the sale of assets in subsidiaries/affiliates
- Losses incurred from a lawsuit
- The loss incurred from a plant shutdown
Below is an example of Restructuring and asset impairment charges in Intel.
source: Intel Website
#2 – Extraordinary Items (Infrequent and Unusual)
The second type of non-recurring item is Extraordinary ItemsExtraordinary ItemsExtraordinary Items refer to those events which are considered to be unusual by the company as they are infrequent in nature. The gains or losses arising out of these items are disclosed separately in the financial statement of the company. (Infrequent or Unusual Items)
Extra-ordinary Items are both infrequent & unusual and are reported net of income tax.
Extraordinary Items Examples
- Compensation from the expropriation of the company’s property
- Uninsured losses incurred by the company as a result of natural calamities like earthquakes, 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 a plant
- Gain or loss from early retirement of debt
- Gain on life insurance/ loss incurred on casualty
- 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 intangible assets
International Financial Reporting Standards (IFRS) don’t recognize the concept of extraordinary items.
Recently, Japan’s Sony Corp estimated $1 billion as earthquake-related damages.
#3 – Discontinued Operations
The third type of non-recurring item is the Discontinued Operations. These non-recurring items are required to be reported 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. if the operation of a part of a firm is either being held for sale or has already been disposed of. For an item to be qualified as a part of discontinued operations, two basic conditions should be fulfilled -:
- Once the component has been successfully disposed of, there is no involvement/ influence by the parent companyParent CompanyA 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. related to financial/ operational matters within the discontinued component.
- The operations and cash flow from the disposal of the component will be eliminated from the parent’s operations.
The impact of discontinued operations appears in the Income Statement, as seen below.
Examples include -:
- A Company sells an entire product lineProduct LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing. with an agreement by the buyer to pay x% of sales as a royalty fee. The company will have no involvement/ influence in the operational/financial decision-making of the spanned-off product line.
- A company sells a product group to a buyer with which cash flows were associated and reported at that level.
Note-: if a company sells just a product from its business portfolio to a buyer, it might not qualify as a discontinued operation if the company is not reporting cash flowsReporting Cash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. at that product level. Also, all contingent liabilities, including interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense. incurred by the seller in the event of the buyer assuming any debts associated with the disposed of 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
The fourth non-recurring item is the changes in Accounting Principles.
Accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. change when there is more than one principle available for applying to a particular financial situation. Changes should be backed by a rationale that proves their relevance. These changes have an impact not only on the current year’s financial statements but also on adjusting the prior period’s financial statements as they have to be applied retrospectively to ensure uniformity. The retrospective implementation ensures proper comparisons between the financial statements of different periods can be made. Usually, an offsetting amount is adjusted to capture the cumulative effect of such changes.
Changes in Accounting Principles Examples
- Change in inventory management principles from LIFO to FIFOLIFO To FIFOFIFO implies that the inventory that was added first to the stock will be removed first, whereas LIFO implies that the inventory that was added last to the stock will be removed first. or Specific identification methodSpecific Identification MethodThe specific identification method is one of the accounting methods for inventory valuation that keeps track of each and every item of inventory used in the company from the time it enters the business until it leaves the business, as well as assigning a cost to each item individually rather than grouping them together. of inventory valuation or vice versa leads to a significant change in the inventory cost.
- Change in the depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. method from the Straight-line method to the Sum of digits or hours of service method also leads to a significant change in how depreciation amount is reported.
In the below-mentioned example, we can see how a P&L statement should represent Extraordinary items, Gain/Loss from Changes in accounting principles, and gains from the disposal of assets. They all are captured below the line, i.e., after calculating income from Continued Operations. Such a separation helps an analyst to identify the true earnings of an organization.
What problem do nonrecurring items pose to Investors and Analysts?
- Investors and analysts perform financial statement analysis to estimate 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 to as “the issue of Earnings Quality.”
- Many companies are increasing their Non-operating income as it helps them hide the losses they incur from their normal business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation..
- An analyst’s immediate job is to identify the main sources of revenue and expenses and the extent to which the company’s earnings depend on them.
- Non –Recurring items are an important source of distortion when 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.
- It 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 must always be aware of the management’s decision to make accounting changes and adjustments as they drastically impact a company’s valuation.
- Senior management is well aware of critical decisions. E.g., when to spin off a business or close a service line, and it uses this very advantage 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, when there is a management change, old projects are written off mainly to show big changes and improvements for future periods.
- Therefore, investors and the Security & Exchange board need to ask questions regarding the relevance of such changes and sell-offs.
- A security analyst should consider all such scenarios while carrying out a company valuation as they encapsulate hidden motives that 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 footnotes of financial statements.
Generally, there are three methods to deal with non-recurring items while performing financial analysis/valuation. They are as follows -:
#1 – Allocate them within the Single Financial year
This approach talks about reporting a non-recurring item within the same financial year. Though allocating gains or losses to a single year doesn’t seem to be the right way to handle such items, it is still preferred when dealing with items that have small amounts attached to them or have very little impact on valuation matrices like EBITDA or Net Income.
#2 – Use Straight line spreading (Distributing them historically)
This approach emphasizes the principle of spreading the non-recurring items over the past accounting periodsPast Accounting PeriodsAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance. to estimate the real earning power of the company. The only demerit 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 they should exclude. There has to be a proper justification for the exclusion, and when they do this, there must be a proper tax adjustment to nullify the gain/loss attached to 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 that emphasizes more the nature of the non-recurring item for deciding which of the three methodologies mentioned above have to be used rather than using one on a standalone basis.
It is suggested that -:
- Small items with less impact on Net Income should be accepted within a financial year.
- If an item is altogether excluded, the proper adjustment should be made 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.