What Are Extraordinary Items?
Extraordinary items were a category of highly unusual and infrequent gains or losses reported separately on a company's income statement. Within the realm of financial accounting, these events were considered distinct from a company's normal, recurring business operations, allowing investors and analysts to better understand the underlying profitability derived from core activities. The classification was part of Generally Accepted Accounting Principles (GAAP) in the United States, designed to segregate non-operational events that could skew the perception of ongoing performance.
History and Origin
The concept of extraordinary items has roots in accounting efforts to provide clearer representations of a company's core operational results. For decades, U.S. GAAP required companies to identify and report events or transactions that were both "unusual in nature" and "infrequently occurring" as extraordinary items. These items were presented separately, net of tax, after income from continuing operations on the income statement. The rationale was to prevent a one-time, significant event from distorting the reported net income, thereby helping users of financial statements assess sustainable earnings.
However, in practice, the criteria for classifying events as extraordinary items became increasingly difficult to apply, leading to inconsistencies and rare usage. Few events truly met the strict "unusual and infrequent" dual criteria; for example, major natural disasters or the September 11 attacks generally did not qualify as extraordinary for most companies, as their impact was not considered unusual for all entities or in all operating environments. Recognizing this complexity and the desire to simplify financial reporting, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2015-01, "Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items," in January 2015. This update effectively eliminated the classification of extraordinary items from U.S. GAAP, aligning it more closely with International Financial Reporting Standards (IFRS), which had previously prohibited their presentation.8 The elimination aimed to reduce the time and cost associated with assessing and reporting such items while maintaining the usefulness of financial information.7
Key Takeaways
- Extraordinary items were rare, non-recurring gains or losses separate from a company's normal business activities.
- They were previously reported on the income statement to distinguish core operational performance from one-off events.
- U.S. GAAP eliminated the concept of extraordinary items in 2015 due to their narrow interpretation and infrequent application in practice.
- Companies now typically report unusual or infrequent events as part of continuing operations, with specific disclosures in the notes to the financial statements or within the management's discussion and analysis (MD&A).
- The elimination aimed to simplify financial reporting and reduce complexity for preparers, auditors, and regulators.
Interpreting the Extraordinary Items
While the formal classification of extraordinary items no longer exists under U.S. GAAP, the underlying events that would have once been categorized as such still occur. These events, which are unusual in nature or infrequent in occurrence (or both), are now presented within a company's income from continuing operations. The challenge for analysts and investors now lies in carefully scrutinizing a company's financial statements and accompanying notes to identify and understand the impact of these non-recurring events on reported revenue, expenses, and overall financial results.
When evaluating a company's performance, it is crucial to distinguish between recurring operational results and the effects of these one-time occurrences. Users of financial statements must adjust their analysis to remove the impact of these unique events to gain a clear picture of sustainable earnings and future prospects. This often involves looking at non-GAAP financial measures provided by companies, as well as delving into the qualitative explanations provided in the footnotes and MD&A.
Hypothetical Example
Consider a hypothetical manufacturing company, "Alpha Corp.," that, in its history, might have reported an extraordinary item.
Scenario (Pre-2015 GAAP):
In 2010, Alpha Corp. owned a small, highly specialized factory in a remote, politically stable country. Unexpectedly, the government of that country suddenly and without warning expropriated the factory, seizing all its assets and providing no compensation. This event was considered:
- Unusual in nature: Not typical for a manufacturing company's operations.
- Infrequent in occurrence: Highly unlikely to happen again or regularly.
Under the old GAAP rules, Alpha Corp. would have reported the significant loss from this expropriation as an extraordinary item on its income statement, net of any tax effects, below its income from continuing operations. This would clearly separate the loss from its normal manufacturing and sales activities, allowing analysts to see its regular operating profit without distortion.
Post-2015 GAAP (How a similar event would be handled today):
If a similar event were to happen today, the loss from the expropriation would be reported as a separate line item within income from continuing operations, likely identified as "Loss on expropriation of assets" or similar. While it wouldn't be labeled "extraordinary," the company would provide detailed explanations in the notes to its financial statements and in the management's discussion and analysis to clarify its nature, amount, and impact on current period results, ensuring transparency for shareholders.
Practical Applications
Although the specific "extraordinary items" classification is no longer used, the underlying need to understand the impact of unusual and infrequent events on financial performance remains critical in various aspects of investing and analysis.
- Investment Analysis: Investors and financial analysts continue to adjust reported net income to remove the impact of non-recurring events. This helps in assessing a company's true operational earnings power and making more informed projections about future profitability. For example, a large, one-time gain from the sale of an asset should not be considered part of a company's recurring revenue stream.
- Regulatory Scrutiny: Regulatory bodies, like the Securities and Exchange Commission (SEC), emphasize transparent disclosures of non-recurring events in a company's MD&A section. The SEC's guidance stresses that companies must identify and discuss known trends, demands, commitments, events, and uncertainties that are reasonably likely to have a material effect on financial condition or operating performance.6 This ensures that information that might have once been an extraordinary item is still communicated clearly to the market.
- Forecasting and Valuation: When building financial models, analysts explicitly separate non-recurring gains or expenses to project a company's future performance based on its core business. This allows for more accurate valuation metrics, such as earnings per share (EPS), which typically exclude these unusual impacts.
Limitations and Criticisms
The elimination of extraordinary items was largely a response to the limitations and criticisms associated with their application. Prior to 2015, the rigorous "unusual and infrequent" criteria meant that very few events actually qualified, even seemingly large, one-off occurrences. This led to inconsistencies in how companies reported similar events, making cross-company comparisons challenging.
A key criticism was the ambiguity in defining what constituted "unusual" and "infrequent," which often led to subjective judgment and debates between companies and auditors. The narrow interpretation meant that many significant, non-recurring events were already being reported within continuing operations, simply categorized as "unusual" or "infrequent" but not "extraordinary." This diluted the effectiveness of the extraordinary item classification.
Post-elimination, while simplification was achieved, a new set of challenges emerged. Companies now have more discretion in how they present and highlight unusual or infrequent events within their continuing operations. This has led to an increased reliance on non-GAAP financial measures, where companies often adjust their reported GAAP earnings to exclude certain items they deem "non-recurring" or "one-time." While these non-GAAP measures can provide additional insights, they also introduce potential for manipulation or a lack of comparability across companies if not clearly defined and reconciled. The SEC has frequently commented on the use of non-GAAP financial measures, emphasizing the need for robust disclosures and transparency to avoid misleading investors.4, 5
Extraordinary Items vs. Discontinued Operations
Extraordinary items were often confused with discontinued operations, but there were key distinctions. Both involved non-recurring events, but their nature and reporting differed significantly:
Feature | Extraordinary Items (Pre-2015 GAAP) | Discontinued Operations (Current GAAP) |
---|---|---|
Definition | Events or transactions that were both unusual in nature and infrequently occurring. | A component of an entity (e.g., a business segment or product line) that has been disposed of or classified as held for sale, representing a strategic shift in operations. |
Nature of Event | Typically, a single event, transaction, or incident (e.g., a natural disaster, an expropriation). | The planned or actual disposal of an entire business segment or distinct set of operations.3 |
Reporting on Income Statement | Presented below income from continuing operations, net of tax, as a distinct line item. | Reported separately from continuing operations on the income statement, presenting the results (profit or loss) of the component until disposal and any gain/loss on disposal, net of tax.2 |
Impact on Core Business | Did not represent a cessation of a significant part of the core business. | Represents the cessation or significant curtailment of a major line of business or geographical area. |
Current Status | Concept eliminated from U.S. GAAP in 2015. | Still a current and significant reporting requirement under U.S. GAAP and IFRS.1 |
While both aimed to isolate non-recurring financial impacts, extraordinary items focused on isolated events, whereas discontinued operations involve the strategic decision to exit a significant part of a business.
FAQs
What replaced extraordinary items in financial reporting?
After the elimination of extraordinary items from U.S. GAAP in 2015, events that would have previously been classified as such are now generally reported as separate line items within a company's income from continuing operations. Companies are required to provide clear and detailed disclosures in the notes to the financial statements and in the MD&A section to explain the nature, amount, and impact of these unusual or infrequent events.
Why were extraordinary items eliminated from GAAP?
Extraordinary items were eliminated primarily due to the strict and often subjective criteria for their classification. In practice, very few events met the dual test of being both "unusual in nature" and "infrequently occurring," leading to inconsistent application and high compliance costs for companies and auditors. The elimination aimed to simplify financial reporting and align U.S. GAAP with international accounting standards.
How do analysts account for unusual events now that extraordinary items are gone?
Analysts still aim to identify and isolate the impact of unusual and infrequent events to assess a company's sustainable profitability. They carefully review the notes to the financial statements, the MD&A, and any non-GAAP financial measures provided by the company. They will often adjust reported earnings to exclude the effects of these items to gain a clearer picture of core operational performance, similar to how they would have before the elimination.