EXECUTIVE
SUMMARY | Material gains and
losses are classified as “extraordinary”
on the income statement when they
are both “unusual” and “infrequent.”
Extraordinary items are reported at the
bottom of the income statement, net of
their tax effects.
FASB Statement no.
145 significantly shortened the list
of extraordinary items by
repealing the requirement that all
early extinguishment of debt be
treated as extraordinary. This
eliminated most gains and losses
previously treated as extraordinary
items.
Whether an event is
unusual depends on the
environment in which the entity
operates, taking into account factors
such as the characteristics of the
industry or industries in which it
operates, the geographical location of
its operations, and the nature and
extent of governmental regulation.
The past occurrence
of an event or transaction
provides some evidence of the
probability of recurrence of that type
of event or transaction in the
foreseeable future in determining
whether the occurrence is sufficiently
infrequent.
Theresa F. Henry,
CPA, Ph.D., is an assistant
professor of accounting and taxation
at Seton Hall University, Stillman
School of Business.
Mark P. Holtzman
, CPA, Ph.D., is an assistant
professor of accounting and taxation
at Seton Hall University, Stillman
School of Business. Their e-mail
addresses are
henrythe@shu.edu
and
holtzmma@shu.edu
, respectively.
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The extraordinary item still
appears on some companies’ income statements, but
it’s much less common than it used to be, largely
because of FASB Statement no.145, introduced in
2002. This continued a trend among
standard-setters toward more restrictive criteria
for which items can be classified as
extraordinary. Material gains and losses
are classified as extraordinary on the
income statement only when they are unusual
and infrequent . Extraordinary items
are reported at the bottom of the income
statement, net of their income tax effects.
The following study surveys more than 16,000
public companies’ financial statements, measuring
the frequency of extraordinary items and
identifying specific types of gains and losses
that have recently been reported as extraordinary.
This article will help practitioners detect gains
and losses that may fit within the narrow
definition of extraordinary items.
THE EXTRAORDINARY ITEM CLUB
Statement no. 145 significantly
shortened the list of extraordinary items by
repealing the requirement of Statement no. 4,
Reporting Gains and Losses From
Extinguishment of Debt, that early
extinguishment of debt be treated as
extraordinary. By 2004, Accounting Trends and
Techniques found just 4 items reported (out
of 600 companies surveyed). Of the 78
extraordinary items reported in 2001, all but
eight related to the early extinguishment of debt.
Our more extensive survey of 16,000
companies indicates less than 0.2% of publicly
traded companies reported extraordinary items in
2004.
SELECTIVITY KEEPS THE CLUB
EXCLUSIVE APB Opinion no. 9,
Reporting the Results of Operations,
issued in 1966, defined extraordinary items
as those “of an extraordinary nature and whose
effects are material.” Examples included disposal
of a plant (or a significant segment of the
business), sale of an investment not acquired for
resale, write-off of goodwill, expropriation of
properties and major devaluation of a foreign
currency. In 1973, APB Opinion no. 30,
Reporting the Results of
Operations—Reporting the Effects of Disposal of
a Segment of a Business, and Extraordinary,
Unusual and Infrequently Occurring Events and
Transactions, tightened the criteria, so
that to be classified as extraordinary, an event
or transaction must be both unusual and
infrequent.
What is “unusual?” To
determine an entity’s ordinary and typical
activities, one must consider the specific
characteristics of the entity, such as the type
and scope of operations, lines of business and
operating policies and environment. The
environment includes factors such as industry or
industries in which it operates, its geographical
location, and the nature and extent of
governmental regulation. Thus, according to APB
Opinion no. 30, an event or transaction may be
unusual for one entity but not for another.
What is “infrequent?”
According to the opinion, an
infrequent event or transaction is one that is not
reasonably expected to recur in the foreseeable
future. Because this determination also depends on
the environment in which an entity operates, what
is extraordinary for one entity may not be for
another. The past occurrence of an event or
transaction provides some evidence of the
probability of recurrence of that type of event or
transaction in the foreseeable future. The
opinion identifies the following gains and losses
not considered extraordinary:
Write-down or write-off of
receivables, inventories, equipment leased to
others, deferred research and development costs,
or other intangible assets.
Gains or losses from exchange or
translation of foreign currencies, including those
relating to major devaluations and revaluations.
Gains or losses on disposals of a
segment of a business.
Other gains or losses resulting from
sale or abandonment of property, plant and
equipment used in the business.
Effects of a strike, including those
against competitors and major suppliers.
Adjustment of accruals on long-term
contracts. |
Properly reporting
nonrecurring gains and losses as
extraordinary items will help
financial statement users exclude
the effects of unusual and
infrequent items when evaluating a
company’s operations.
FASB Statement no.
145 did not completely eliminate
extraordinary treatment for
material gains and losses from
early extinguishment of debt. It
eliminated the FASB Statement
no. 4 requirement that all
such gains and losses be
treated as extraordinary. Early
extinguishment of debt still may
be an extraordinary item if its
occurrence is unusual
and infrequent
under FASB Statement no.
145 and APB Opinion no. 30.
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Companies should disclose the nature and
financial effects of each event or transaction on
the face of the income statement or in notes to
the financial statements. FASB’s guidance
in EITF 01-10 specifies that costs and losses
associated with the terror events of Sept. 11,
2001, should be classified as part of income from
continuing operations. The Task Force concluded
these events were so wide-ranging and pervasive
that extraordinary item treatment would not
effectively communicate their financial effects.
The EITF did not provide accounting guidance for
the effects of Hurricane Katrina. In practice,
then, the EITF eliminated both acts of terror and
most natural disasters from the repertoire of
extraordinary events. AICPA’s Technical Practice
Aid 5400.05, Accounting and Disclosure
Guidance for Losses From Natural
Disaster—Nongovernmental Entities, provides
further guidance on how to treat such losses.
| Why Join
the Club?
Analysts and other public
company financial statement
users usually focus on net
income before (1) gains or
losses on disposal of a
segment of operations and (2)
extraordinary gains and
losses. Because they do not
expect these unusual and
infrequent items to recur,
analysts generally ignore them
when projecting future profits
and cash flows. Accordingly,
by classifying losses as
extraordinary, company
managers can increase
perceived net income,
financial users’ perception of
profitability and analysts’
expectations for future net
income. Furthermore,
company managers wishing to
convey stable and predictable
profit trends would want to
report net income that is
“smoothly increasing.” One way
to do that is by reclassifying
unusual and infrequent gains
and losses out of income from
continuing operations and into
extraordinary items. This fits
with the overall theory that
items most indicative of
future performance—revenues
and expenses from selling and
buying merchandise, for
example—should appear at the
top of the income statement,
while items least indicative
of future performance—unusual
and infrequent gains and
losses—should appear at the
bottom of the income
statement.
Additionally, reporting
losses as extraordinary can
increase perceived
profitability. FASB’s
increasingly tight standards
for extraordinary items seem
designed to avoid the type of
earnings manipulation that
misleads investors.
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MEET THE MEMBERS We
searched the Compustat database, which includes
the financial statements of 16,378 publicly traded
companies, for extraordinary gains and losses. For
2004, the most recent year available, we found
just 27 companies, or 0.16% of the total,
reporting extraordinary items. The most
common extraordinary item was negative goodwill
(11 companies or 41% of the total number of
extraordinary items reported). In a business
combination, if the fair value of the net assets
acquired exceeds the cost of the acquired entity,
the difference would be recorded as an
extraordinary gain under FASB Statement no. 141.
The next most common item resulted from
early extinguishment of debt, reported by just
five companies (19% of those reporting
extraordinary items). As noted, Statement no. 145
did not completely eliminate extraordinary
treatment for material gains and losses from early
extinguishment of debt. It eliminated the former
Statement no. 4 requirement that all such gains
and losses be treated as extraordinary items.
Under Statement no. 145, as under APB Opinion no.
30, such items must be unusual and infrequent to
receive extraordinary treatment (see Exhibit 1).
One other company originally reported an
extraordinary gain on extinguishment of debt in
2004 but later amended its income statement to
change this classification. |
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Disclosure
Example
Extraordinary
Item: Early
Extinguishment of
Debt
During 1989, the
Company acquired
from Competitive
Technologies Inc.
(“Competitive”)
substantially all of
the assets that
comprise the
Company’s business
through an Asset
Purchase Agreement.
The purchase price
was $6,000,000 to be
paid with $500,000
down and $250,000
per year, increasing
at a rate of five
percent per year.
The Company recorded
the assets and the
obligation net of
imputed interest.
The Company
defaulted on the
obligation to
Competitive and
during 1994 the
Company entered into
negotiations with
them for relief with
respect to the note
payable. As a result
of pending
litigation
instituted during
August 2003, in
October 2003 the
Company and
Competitive entered
into a settlement
agreement in
connection with this
debt. Under the
terms of the
settlement
agreement, all prior
obligations of the
Company have been
irrevocably
terminated in
exchange for a
$1,250,000
non-interest-bearing
installment note,
secured by the
assets of the
Company subordinate
only to the security
interest granted to
UNIINVEST Holding AG
(Note 7). The
settlement calls for
a $100,000 payment
on the signing of
the agreement (paid)
and quarterly
payments beginning
on December 31,
2003, for the
greater of (i)
$100,000 or (ii) an
amount equal to 50
percent of the
royalties received
by the Company from
Bausch & Lomb
during the quarter
ending on the
payment due date. On
the date of the
settlement
agreement, the
Company recognized a
one-time
extraordinary gain
of approximately
$1,952,000 which is
net of associated
expenses and
applicable income
taxes of $1,178,050.
At June 30, 2004,
the Company owed
$838,139 on this
note.
Unilens Vision
Inc.: Form 20-F, FYE
6/30/04, p. 46.
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Four companies (15%) reported extraordinary
gains or losses from discontinuance of regulatory
accounting. When an entity no longer uses FASB
Statement no. 71, Accounting for the Effects
of Certain Types of Regulation, the
resulting gains and losses should be treated as
extraordinary under FASB Statement no. 101. This
could happen when there is deregulation or a
change in the regulation method or competitive
environment for the enterprise’s regulated
services or products. The gain or loss would
result from eliminating assets and liabilities
(under Statement no. 71) from the balance sheet.
Three companies (11%) reported extraordinary
gains or losses from first-time consolidation of
variable-interest entities. When consolidating a
variable-interest entity for the first time, under
FASB Interpretation no. 46R, one must record an
extraordinary loss, in lieu of goodwill, if the
entity is not defined as a business. As with
typical consolidations under Statement no. 141,
companies incurring negative goodwill on a
first-time consolidation of a variable-interest
entity will record an extraordinary gain.
One company reported an extraordinary gain on
involuntary conversion of assets due to a fire
(see Exhibit 2). Two more companies had reported
extraordinary items for involuntary conversion of
assets due to hurricanes but subsequently amended
their income statements to account for this event
as an unusual, but not extraordinary, item.
Because hurricane losses do not generally meet the
criteria of unusual and infrequent, companies have
not reported these losses as extraordinary. Six
hurricanes, not classified as extraordinary in
2004, would indicate that hurricane losses do not
meet the criteria as unusual or infrequent. (See
AICPA Technical Practice Aid 5400.05.)
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Disclosure
Example
Extraordinary
Item: Fire
On
March 28, 2003, the
Company had an
accidental fire at
the Junction, Texas,
plant. The Company
was given permission
to begin demolition
and the rebuilding
of a portion of the
production facility
in April 2003. The
initial restoration
project, completed
in May 2003,
included the rebuild
of one extrusion
line that had been
partially damaged,
electrical system
replacement and roof
replacement. The
rebuild of the
second extrusion
line was completed
in April 2004. The
Junction plant is
fully insured for
fire damage and
business
interruption.
Through December 31,
2004 and 2003, the
Company had received
$6.0 million and
$5.4 million,
respectively, in
insurance proceeds
related to this
incident.
Due to the
Junction facility
fire, gross assets
were written down by
approximately $4.91
million, along with
the associated
accumulated
depreciation on
those assets in the
amount of $3.96
million, resulting
in a net book value
decrease in assets
of about $950,000.
At December 31, 2004
and 2003,
approximately $6.4
million and $3.9
million,
respectively, had
been invested in
reconstructing the
Junction facility.
Insurance proceeds
received to
reimburse costs
incurred to
reconstruct the
facility resulted in
gains of $173,536
and $2,962,041 for
the years ended
December 31, 2004
and 2003,
respectively.
Additionally, the
Company recorded
$11,213 in business
interruption
insurance during
2004, including
$8,720 to replace
lost income and
$2,493 to cover
fixed expenses.
During 2003, the
Company recorded
$1,366,682 in
business
interruptions
insurance, including
$1,125,372 to
replace lost income
and $241,310 to
cover fixed
expenses. At
December 31, 2003,
approximately
$484,000 was
included in accounts
receivable for
expected insurance
reimbursements.
AERTA, Inc.: Form
10-K, FYE 12/31/04,
p. F-24.
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The remaining three items include: write-up of
a regulatory asset, a change in a retirement fund,
and receipt of escrow moneys from bankruptcy. Two
other companies that had originally reported
extraordinary items (one for reverse merger and
one for litigation) later amended their income
statements to change this classification.
IS IT EXTRAORDINARY? In
evaluating whether an event or transaction is
extraordinary, CPAs should look to the guidance of
standards outlined in this article and common
practice. Our survey of common practice indicates
that few gains and losses on early extinguishment
of debt meet the criteria of being unusual and
infrequent. Furthermore, most hurricane and fire
damage is not reported as extraordinary. This
leaves few transactions that are sufficiently
unusual and infrequent to join one of accounting’s
most exclusive clubs. |