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Extraordinary Gains and losses, Their Significance to the Financial Analyst

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Accounting Principles Board Opinion No. 9 “Reporting the Results of Operations”. This Opinion did bring about an improvement of practice by requiring the inclusion of all extraordinary gains and losses in the determination of net income. Nevertheless it has, since its inception, labored under a fatal flaw: it is based on some very vague and erroneous concepts of what the real significance of extraordinary items is to the intelligent user of financial statements.
The net result has been that, rather than being helpful to the interpretation of the income statement, the presentation of extraordinary gains and losses, has, in general, contributed to confusion and in many cases to inferences that have been downright misleading.

This article is devoted to an examination of this most important and most neglected aspect of the problem.

Why do We Identify Extraordinary Gains and Losses:

Both the evaluation of current earnings levels and the projection of future earnings rely importantly on the separation of the stable elements of income and expense from those which are random, non-recurring and erratic in nature.

Stability and regularity are important dimensions of the quality of earnings on which the forecaster relies in making his earnings projections. Thus, in order to separate the relatively stable elements of income and expense from the random or erratic elements it is important, as a first step, to identify those gains and losses that are nonrecurring and unusual as well as those which are truly extraordinary.

Significance of Accounting Treatment and Presentation :

The accounting for, and the presentation of, extraordinary gains and losses has always been subject to controversy. One of the basic reasons for the controversy is reporting management’s great interest in the manner in which periodic results are reported. This concern is reinforced by a widespread belief that most investors and traders accept the reported net income figures, together with the modifying explanations that accompany them, as true indices of performance.

Extraordinary gains and losses often become the means by which managements attempt to modify the reported operating results. Quite often the accompanying explanations are slanted in a way designed to achieve the impact and impression desired by management.

Analysis and Evaluation:

The basic objectives in the evaluation of extraordinary items by the analyst are:

1.To determine whether a particular item is to be considered “extraordinary” for purposes of analysis; that is, whether it is so unusual that it requires special adjustment in the evaluation of current earnings levels and of future earning possibilities.

2.  To decide what form the adjustment for items considered “extraordinary” should take. Determining Whether an Item of Gain or Loss Is Extraordinary :

Common classification of items

1.Non-recurring Operating Gains and Losses.

2.Recurring Non-operating Gains or Losses.
3.Non-recurring, Non-operating Gains or Losses.

Non-recurring Operating Gains and Losses:

By “operating” we usually identify items connected with the normal and usual operations of the business.

The concept of recurrence is one of frequency. There are no predetermined generally accepted boundaries dividing the recurring event from the non-recurring. An event occurring once a year can be definitely classified as “recurring”. An event, the occurrence of which is unpredictable and which in the past has either not occurred or occurred very infrequently, may be classified as non-recurring.

Non-recurring operating gains or losses are, then, gains or losses connected with or related to operations that recur infrequently or unpredictably. e.g.  foreign operations give rise to exchange adjustments because of currency fluctuations or devaluations.

Depending on the type of business and other factors, a degree of variability and abnormality must be expected.

In considering how to treat non-recurring, operating gains and losses the analyst would do best to recognize the fact of inherent abnormality and the lack of a recurring annual pattern in business and treat them as belonging to the results of the period in which they are reported.

Objectives of a business has undergone considerable revision in modem financial theory, which considers the main objective of management to be increasing the capital of the owners, or enhancing the value of the common stock rather than “baking bread” or any other specific objective.

The analyst should not be bound by the accountant’s concept of “normal operations”, hence he can usefully treat a much wider range of gains and losses as being derived from “operations”— reinforcing our conclusion that he should consider most non-recurring, operating gains and losses as part of the operating results of the year in which they occur.

Some items require separation from the results of a single year. The relative size of an item could conceivably be a factor requiring such treatment. In this case the best approach is to emphasize average earnings experience over, say, five years rather than the result of a single year. This approach of emphasizing average earnings becomes almost imperative in the case of enterprises that have widely fluctuating amounts of non-recurring and other extraordinary items included in their results.

Recurring Non-operating Gains or Losses:

This category includes items of a non-operating nature that recur with some frequency. Examples interest income and the rental received from employees who rent company owned houses.

While items in this category are classified as “extraordinary” in published financial statements, the narrow definition of “non-operating” which they involve, as well as their recurrent nature, are good reasons why they should not be excluded from current results by the analyst. They are, after all, mostly the result of the conscious employment of capital by the enterprise and their recurrence requires inclusion of these gains or losses in estimates designed to project future results.

Non-recurring, Non-operating Gains or Losses:

Not only are the events here non-repetitive and unpredictable, but they do not fall within the sphere of normal operations. In most cases these events are extraneous, unintended and unplanned. Business is ever subject to random shocks, be they natural or man-made, including for example: substantial uninsured casualty losses, such as those arising from fires, storms, floods, etc.

Of the three categories this one comes closest to meeting the criterion of being “extraordinary”. Nevertheless, truly unique events are very rare. What at the time seems unique may, in the light of experience, turn out to be the symptom of a new set of circumstances that may continue to affect earning power.

Effect of Extraordinary Items on Resources:

Every extraordinary gain or loss has a dual aspect. When it records a gain (whether extraordinary or not) a business also records an increase in resources. Similarly, when a business records a loss it also records a reduction of resources.

Since return on investment relates net income to resources, incurring extraordinary gains and losses will affect this important measure of profitability.. In other words, if earnings and events are to be used to make forecasts, then extraordinary items have implications beyond past performance. If an extraordinary loss results in the destruction of capital on which a certain return is expected, for example, that return may be lost to the future. Conversely, an extraordinary gain will result in an addition to resources on which a future return may be expected.

This means that in projecting profitability and return on investment, the analyst must take into account the effect of recorded extraordinary items as well as the likelihood of the occurrence of future events that may result in extraordinary items.

Implications for Accounting Profession:

The present practice in this area is not useful to the professional analyst and may be downright misleading to others. It is useful in helping certain managements to divert attention from their mistakes, their failures and from the risks which are inherent in their operations.

It is high time for the accounting profession to abandon the notion that it can pre-analyze and interpret the income statement for the reader by means of the loose principles of identification of extraordinary items existing today. Even assuming that such built-in interpretation is desirable, it would require a major research effort by the accounting profession in conjunction with the informed users of financial statements.

*The above article is a summary of paper Extraordinary Gains and losses, Their Significance to the Financial Analyst          by Leopold A. Bernstein, FINANCIAL ANALYSTS JOURNAL / NOVEMBER – DECEMBER 1972*

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Written by Dr. Garima Kapoor

February 23, 2010 at 11:55 pm

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