Subject 6. Non-Recurring Items and Non-Operating Items

The goal of analyzing an income statement is to derive an effective indicator to predict future earnings and cash flows. Net income includes the impact of non-recurring items, which are transitory or random in nature. Therefore, net income is not the best indicator of future income. Recurring pre-tax income from continuing operations represents the company's sustainable income and therefore should be the primary focus of analysis.

Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring," especially those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring," regardless of their accounting labels.

There are four types of non-recurring items in an income statement.

1. Discontinued operations

Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized.

• Subsidiaries and investees also qualify as separate components.
• Disposal of a portion of a business component does not qualify as discontinued operations. Instead, this is recorded as an unusual or infrequent item.

2. Extraordinary items

Extraordinary items are BOTH unusual in nature AND infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax.

Common examples are:

• Expropriations by foreign governments.
• Uninsured losses from earthquakes, eruptions, and tornadoes.

Note that gains and losses from the early retirement of debt used to be treated as extraordinary items; SFAS No. 145 now requires them to be treated as part of continuing operations.

3. Unusual or infrequent items

These are either unusual in nature OR infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations.

Common examples are:

• Gains or losses from disposal of a portion of a business segment.
• Gains or losses from sales of assets or investments in affiliates or subsidiaries.
• Provisions for environmental remediation.
• Impairment, write-offs, write-downs, and restructuring costs (such as those costs related to the integration of acquired companies).

4. Changes in accounting principles

Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on an after-tax basis. They are typically reported through retrospective application, which means that the financial statements for all fiscal years shown in a company's financial report are presented as if the newly adopted accounting principle had been used throughout the entire period.

Changes in accounting estimates, such as changes in asset lives or salvage value when recording depreciation expenses, are not considered changes in accounting principles. The impact of such a change is only prospective, and no retroactive or cumulative effects are recognized.

A change from an incorrect to an acceptable accounting method is treated as an error and its impact is reported as a prior period adjustment.

Non-operating Items: Investing and Financing Activities

Non-operating items are reported separately from operating items. For example, if a non-financial service company invests in equity or debt securities issued by another company, any interest, dividends, or profits from sales of these securities will be shown as non-operating income.

Summary

Non-recurring items should be scrutinized to assess whether they are truly "non-recurring." For example, gains or losses from the sale of fixed assets are classified as unusual or infrequent items. However, for a car rental company that retires part of its fleet of cars annually, such gains or losses are rather recurring in nature. Some non-recurring charges are, in fact, prior period expenses taken too late or future expenses taken too early. For example, asset write-downs may indicate that prior period depreciation or amortization changes were insufficient. Therefore, completely ignoring such non-recurring items in financial analysis may result in an overestimation of a company's earning trend.