Exceptional items

LINK_POOL:

What Is Exceptional Items?

Exceptional items are material transactions or events that are considered unusual due to their nature or infrequent occurrence, but not necessarily both, and are disclosed separately on a company's income statement or in its notes to the financial statements. These items fall under the broader category of financial reporting and are presented separately to provide a clearer view of a company's core operating performance. While they may not be "extraordinary" as once defined by some accounting standards, exceptional items are distinct from a company's routine business activities and are generally not expected to recur in the predictable future. The identification and separate disclosure of exceptional items aim to prevent distortion of a company's underlying profitability and enable more accurate financial analysis.

History and Origin

The concept of separately reporting unusual or non-recurring events in financial statements has evolved significantly over time. Historically, under Generally Accepted Accounting Principles (GAAP) in the United States, there was a specific classification known as "extraordinary items." These were defined by strict criteria: they had to be both unusual in nature and infrequent in occurrence. However, this definition led to considerable debate and inconsistent application. In January 2015, the Financial Accounting Standards Board (FASB) published Accounting Standards Update (ASU) 2015-01, which formally eliminated the concept of extraordinary items from GAAP for fiscal years beginning after December 15, 2015.²¹, ²², ²³

This change aimed to simplify income statement presentation and reduce the burden on preparers and auditors.¹⁹, ²⁰ Prior to this, the International Accounting Standards Board (IASB) had already removed "extraordinary items" as a line item from International Financial Reporting Standards (IFRS) in 2002, with IAS 1 explicitly stating that an entity cannot present any items of income or expense as extraordinary items in financial statements.¹⁶, ¹⁷, ¹⁸ Instead, both GAAP and IFRS now require that material items that are unusual or infrequent be reported as separate components of income from continuing operations or disclosed in the notes to the financial statements.¹³, ¹⁴, ¹⁵

Key Takeaways

• Exceptional items are material events or transactions that are unusual in nature or infrequent in occurrence, but not necessarily both.
• They are disclosed separately on the income statement or in the footnotes to provide a clearer picture of a company's recurring operations.
• The classification of "extraordinary items" has been eliminated under both U.S. GAAP and IFRS, replaced by the broader concept of unusual or infrequent items (often referred to as exceptional items).
• Their separate reporting helps investors distinguish between sustainable operating performance and one-time events.
• Companies often adjust financial metrics to exclude the impact of exceptional items when presenting non-GAAP measures.

Interpreting the Exceptional Items

When interpreting exceptional items, it is crucial to understand that these amounts can significantly impact reported financial figures, such as net income and earnings per share. Analysts and investors typically scrutinize these items to determine their true impact on a company's sustainable profitability. For instance, a large gain from the sale of a property, while boosting current period profits, is unlikely to recur in the future and should not be considered part of the company's regular operating income.

The goal of separately disclosing exceptional items is to help users of financial statements form a more accurate assessment of a company's core business performance and its potential for future earnings. Companies often use these disclosures to present "adjusted" earnings figures, which remove the effect of these non-recurring events. However, investors should critically evaluate these adjustments, as the definition of what constitutes an "exceptional" or "non-recurring" item can sometimes be subject to management discretion. The SEC has provided guidance on the use of non-GAAP financial measures, emphasizing that they should not be misleading and must be reconciled to the most comparable GAAP measure.¹⁰, ¹¹, ¹²

Hypothetical Example

Consider a fictional manufacturing company, "Widgets Inc.," that produces industrial components. In its fiscal year ending December 31, 2024, Widgets Inc. reports the following:

• Revenue: $500,000,000
• Cost of Goods Sold: $300,000,000
• Operating Expenses: $150,000,000

During the year, the company's main factory, located in a region not typically prone to such events, suffered significant damage from a rare, severe hailstorm. The uninsurable repair costs amounted to $10,000,000. Additionally, Widgets Inc. decided to sell an outdated, non-core manufacturing facility that had been idle for several years, resulting in a gain of $5,000,000.

On Widgets Inc.'s income statement, these events would be presented as follows:

¹²³, ⁴, ⁵⁶, ⁷⁸, ⁹