Understanding Extraordinary Items in Financial Statements

An extraordinary item is an accounting term that refers to an abnormal gain or loss that is not generated from the ordinary business operations of a company, is infrequent in nature, and is unlikely to recur in the foreseeable future. Extraordinary items are disclosed separately in the financial statementsThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are of the company.

Summary

• An extraordinary item is an accounting term that refers to an abnormal gain or loss that is not generated from the ordinary business operations of a company, is infrequent in nature, and is unlikely to recur in the foreseeable future.
• Extraordinary gains and losses are often excluded by financial analysts while calculating the price-earnings ratio of a company to get a better sense of its profitability.
• Today, GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) do not recognize the formal use of extraordinary items; it was eliminated in January 2015 to reduce the cost and complexity faced by companies in making financial statements.

Features of an Extraordinary Item

1. Materiality

Transactions exceeding the material threshold of a company will qualify as an extraordinary item. Materiality depends upon the relative size of the company and the industry to which the company belongs.

For example, a royalty of $10,000 earned by a street vendor for selling his recipe to a restaurant chain will be classified as an extraordinary gain as it is a substantial amount relative to his/her annual profit.

However, the same amount received by a multinational restaurant chain will not be unusual; rather, it will constitute the ordinary business operations of the company.

2.  Rare/Unusual in nature

Transactions termed as extraordinary do not occur on a day-to-day basis. For example, an electrical appliance company discontinuing its line of refrigerators and shutting down the product’s manufacturing units is an event unlikely to recur in the future, and thus can be classified as an extraordinary item.

Purpose of an Extraordinary Item

Rare but significant events are treated as extraordinary items to prevent them from skewing a company’s regular earnings. Extraordinary items are often excluded by financial analysts while calculating the P/E ratioPrice Earnings RatioThe Price Earnings Ratio (P/E Ratio is the relationship between a company’s stock price and earnings per share. It provides a better sense of the value of a company. of a company to get a better sense of its profitability.

Companies disclose extraordinary items separately in their financial statements to give investors a more accurate picture of their ongoing expenses and incomes. At the same time, classifying a major loss as an extraordinary item may allow a company to depict a better picture of its financial performance.

To maintain standard accounting practices across companies, GAAP (Generally Accepted Accounting Principles)GAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial and IFRS (International Financial Reporting Standards) specify the treatment of extraordinary items in the books of companies.

Exceptions

GAAP clearly specifies that gains or losses on the sale of an asset, lease of equipment to another company, foreign currency conversion, the effect of a labor strike, or abandonment of property must not be classified as extraordinary items.

Treatment of Extraordinary Items under GAAP and IFRS

In a GAAP update in January 2015, the formal use of extraordinary items was eliminated by the Financial Accounting Standards Board (FASB) to reduce the cost and complexity faced by companies in making financial statements.

Before 2015, extraordinary gains and losses (net of taxes) were disclosed separately on the P&L Statement after the income from day-to-day operations. Today, while companies still need to disclose any unusual transaction or event, they neither have to classify it as an extraordinary item nor evaluate their impact on income tax.

The IFRS also does not recognize extraordinary items and allows companies to disclose them under the usual sub-heads of revenue, finance costs, etc.

Related Readings

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