Extraordinary transactions

What Are Extraordinary Transactions?

Extraordinary transactions, in the context of financial accounting, were specific events or transactions that were both unusual in nature and infrequent in occurrence for a particular entity, and thus considered outside of its typical business activities. These items had a material impact on a company's financial results and were historically presented separately on the income statement to provide clarity to investors. While the concept of extraordinary items has largely been eliminated from U.S. Generally Accepted Accounting Principles (GAAP) since 2015, understanding their historical treatment is crucial for analyzing older financial statements and appreciating the evolution of financial reporting. This classification falls under the broader category of corporate finance, specifically financial accounting standards.

History and Origin

The concept of extraordinary items originated from efforts to standardize how companies reported unusual events that significantly impacted their profitability. The Accounting Principles Board (APB) Opinion No. 30, issued in 1973, established the stringent criteria for classifying an event as extraordinary: it had to be both "unusual in nature" and "infrequent in occurrence." This meant the event was highly abnormal and clearly unrelated to, or only incidentally related to, the ordinary activities of the business, and it was not reasonably expected to recur in the foreseeable future.

Over time, the application of these criteria proved challenging and led to inconsistencies. For example, initially, certain gains and losses from the early extinguishment of debt were often required to be classified as extraordinary. However, the Financial Accounting Standards Board (FASB) later issued Statement No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections," in April 2002, which effectively eliminated the mandatory extraordinary item classification for most debt extinguishments unless they met the strict APB Opinion No. 30 criteria.¹⁰, ¹¹ This change significantly reduced the number of items categorized as extraordinary. By 2004, a survey of 600 companies found only four items reported as extraordinary.⁹

The trend towards restricting the use of "extraordinary items" continued. In January 2015, the FASB issued Accounting Standards Update (ASU) No. 2015-01, "Income Statement—Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items." T⁷, ⁸his update officially eliminated the concept of extraordinary items from U.S. GAAP for fiscal years beginning after December 15, 2015, citing that such events were "extremely rare" in practice and involved significant time and cost for preparers and auditors to assess. T⁶he objective was to simplify income statement presentation.

⁵## Key Takeaways

• Extraordinary transactions were defined as events or transactions that were both unusual in nature and infrequent in occurrence.
• They had a material impact on a company's financial statements and were presented separately after income from continuing operations.
• The Financial Accounting Standards Board (FASB) eliminated the concept of extraordinary items from U.S. GAAP in January 2015, effective for fiscal years beginning after December 15, 2015.
• Events that would have previously been classified as extraordinary are now typically reported as a separate component of income from operations if they are unusual or infrequent (but not both), or disclosed in the footnotes to the financial statements.
• International Financial Reporting Standards (IFRS) never recognized the concept of extraordinary items, leading to further divergence in reporting practices before the U.S. GAAP change.

Interpreting Extraordinary Transactions

Historically, the separate presentation of extraordinary transactions aimed to help users of financial statements distinguish a company's normal operating performance from the impact of highly unusual, one-time events. This allowed for better assessment of a company's sustainable earnings power. When extraordinary items were presented, they appeared net of their tax effects, meaning the reported figure already accounted for any related tax benefits or liabilities.

Despite their elimination from GAAP, the underlying events that would have triggered an extraordinary classification still occur. Analysts and investors today must still carefully examine disclosures in a company's annual report and quarterly reports for significant, one-off events that may distort reported earnings and cash flows. Such events, while no longer labeled "extraordinary," can still significantly impact a company's net income and require careful consideration when evaluating financial performance.

Hypothetical Example

Consider "Alpha Corp.," a manufacturing company that historically operated solely in the Midwest United States. In 2010, before the elimination of extraordinary items, a massive, unprecedented earthquake (an extremely rare event in the Midwest) destroyed Alpha Corp.'s primary factory. The damage resulted in an uninsured loss of $50 million. This event would have qualified as an extraordinary transaction because it was both unusual in nature (not typical for a manufacturing company, especially in that geographical area) and infrequent in occurrence (an earthquake of that magnitude was not expected to recur).

On Alpha Corp.'s 2010 income statement, after reporting its normal operating results, the $50 million loss (net of any tax benefits) would have been presented as a separate line item labeled "Extraordinary Loss from Earthquake." This presentation would have clearly signaled to investors that this significant loss was a one-time event, unrelated to the company's core manufacturing operations. Today, such a loss would be reported within continuing operations, potentially with detailed disclosure in the footnotes as an "unusual or infrequent event."

Practical Applications

While the specific separate line item for extraordinary transactions is no longer used under U.S. GAAP, the underlying principle of identifying and understanding the impact of unusual and infrequent events remains critical for financial analysis. These types of events often show up in areas like:

• Financial Analysis: Analysts still adjust reported earnings to exclude the impact of non-recurring, significant events (which might have been extraordinary items previously) to get a clearer picture of a company's core operational performance. This is crucial for comparing companies or evaluating trends.
• Valuation: When valuing a company, future earnings projections should ideally exclude the impact of one-time events to reflect sustainable operations.
• Risk Assessment: Identifying the nature and magnitude of past unusual or infrequent events helps assess a company's exposure to similar risks in the future, even if those events are not classified as "extraordinary." For instance, companies operating in hurricane-prone regions will disclose risks related to natural disasters.
• Regulatory Filings: Public companies are still required to disclose material unusual or infrequent events in their SEC filings, such as 10-K annual reports and 10-Q quarterly reports, ensuring transparency even without the "extraordinary" label.

⁴## Limitations and Criticisms

The primary criticism of extraordinary transactions, which ultimately led to their elimination from GAAP, was the subjective nature of the "unusual" and "infrequent" criteria. What might be unusual for one company or industry could be a recurring event for another. For example, a hurricane loss might be extraordinary for a manufacturing plant in the Midwest but not for a coastal resort property. This subjectivity led to inconsistencies in reporting across companies and industries, making true comparability difficult.

Critics also argued that the separate classification could potentially be misused to "clean up" the ordinary operating results, making a company's ongoing performance appear better than it actually was by segregating negative, albeit rare, events. Furthermore, the rarity of events truly meeting the criteria for extraordinary classification (as few as 4 instances in 600 surveyed companies in 2004) led the FASB to conclude that the cost and complexity of maintaining the concept outweighed its benefits. T², ³he shift aims to improve the "earnings quality" by reducing opportunities for potential earnings management and enhancing transparency in financial reporting, although some academic research indicates that changes in accounting standards, such as new revenue recognition rules, can still affect earnings quality.

¹## Extraordinary Transactions vs. Nonrecurring Items

The distinction between extraordinary transactions and nonrecurring items has historically been a point of confusion in financial accounting. Prior to the 2015 GAAP change, the key difference lay in the strictness of the criteria.

With the elimination of the "extraordinary items" concept from GAAP, the distinction has become largely irrelevant. Events that previously might have met the extraordinary criteria are now generally treated as unusual or infrequent items. These items, along with other nonrecurring items, are typically included within a company's income from continuing operations, with additional detail provided in the footnotes to the financial statements. This places more responsibility on the financial statement user to identify and assess the impact of such events on a company's true operating performance.

FAQs

What happened to extraordinary transactions in financial reporting?

The concept of extraordinary transactions was eliminated from U.S. GAAP in January 2015 by the FASB. Events that previously qualified as extraordinary are now typically reported as unusual or infrequent items within income from continuing operations or disclosed in the footnotes.

Why were extraordinary items eliminated?

They were eliminated primarily due to the subjective nature of the "unusual and infrequent" criteria, which led to inconsistent application. Additionally, such events were genuinely rare in practice, and the cost and effort of assessing and reporting them were deemed to outweigh the benefits to financial statement users. This also aligns U.S. GAAP more closely with IFRS, which never recognized the concept.

Are there still events considered "extraordinary" in business?

Yes, events that are genuinely unusual and infrequent still occur in business, such as significant natural disasters or certain one-time legal settlements. However, they are no longer given a distinct "extraordinary item" classification on the income statement under U.S. GAAP. Instead, they are typically reported as a component of income from continuing operations or disclosed in the financial statement footnotes to ensure transparency.

How do investors account for these events now?

Investors and analysts must now carefully review a company's financial statement disclosures for detailed explanations of significant unusual or infrequent events. They may choose to adjust reported earnings per share or other profitability metrics to remove the impact of these non-recurring items when evaluating a company's sustainable performance.

Is the term "extraordinary item" still used anywhere?

While no longer a formal GAAP classification for public company financial statements, the term "extraordinary event" or "extraordinary circumstance" might still be used informally in discussions or in certain contractual agreements to describe highly unusual and unforeseen situations. However, for formal accounting standards, the classification has been removed.