What are Extraordinary Items?

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.

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 company’s day-to-day business operations.

Some of the critical aspects are:

 Materiality

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.read more 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 extraordinary item 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.read more 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.

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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.read more 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 segmentsGain 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 segmentsLoss on account of losing a legal case which has led to colossal tax penaltiesLoss 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.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 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.read more of the following business assets is in the normal course of business. A company should not treat these as an extraordinary items:

  • InventoriesAccounts 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.
  • read moreAmortization 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.read moreLoss or gain on account of foreign currency exchange and other transactionsSale 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.read more 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.

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. 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.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.

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

This article has been a guide to what extraordinary items are and their meaning. Here we discuss features and types of extraordinary items with detailed explanations. You may learn more about financing from the following articles –

  • List of Balance Sheet ItemsList Of Balance Sheet ItemsAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet.read moreFormula of Price TargetFormula Of Price TargetPrice Target in the context of stock markets, means the expected valuation of a stock in the coming future and the valuation may be done either by the stock analysts or by the investors themselves. For an investor, price target reflects the price at which he will be willing to buy or sell the stock at a particular period of time or mark an exit from their current position.read moreProject Planner Excel TemplateProject Planner Excel TemplateA project planner template, also known as a project tracker, is a tool used by project managers to track the progress of a project, make amendments, and manage any changes.read moreNet LossNet 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.read more