Irregular Items Related to The Income Statements

Whether we are using a single step income statement nor a multiple step income statement, flexibility in the presentation of the components of the income statement data has been permitted. However there are two important areas that should be included relate to income and how certain unusual or irregular items should be reported.

Unusual or irregular items or irregular transactions encompasses transactions and other events that are derived from developments outside the normal operations of the business. There are several concepts concern with this unusual or irregular items. Should irregular gains and losses and corrections of revenues and expenses of prior years be closed directly to retained earnings and not be reported in the income statement ? Or should they first be presented in the income statement and then carried to retained earnings along with the net income or loss for the period ?

I.   Current Operating Performance Concept

According to this concept, the net income should show only the regular, recurring earnings of the business. Irregular gains and losses do not reflect an enterprise’s future earning power. Therefore irregular gains and losses should not be included in computing net income but should be carried directly to retained earnings as special items. However many readers are not trained to differentiate between regular and irregular items, so it would be confused if such items were included in computing net income.

II.   All Inclusive Concept

According to this concept, irregular items should be included in net income because any gain or loss by the concern whether directly or indirectly related to operation will contribute to its long run profitability. Irregular gains and losses can be separated from regular operations to arrive at income from operations but income for the year should include all transactions.

When judgment is allowed to determine irregular items, a danger of manipulating income data will arise. A recent study noted that management sometimes reports unusual losses as non-recurring but reports unusual gains as part of regular income. This kind of presenting misleading information by managements to investors and creditors just to impress that they are not seriously in troubled.

For example, a company directly wrote off $20 million as losses to retained earnings. By doing this, the company enables to report earning per share of $1.13 . If the company write off $20 million as losses to expense, the company would have reported a loss of 87 cents per share. It could be more advantage for a company to run one time losses through retained earnings but gains through income.

According to all inclusive concept this flexibility should not be allowed because it leads to poor financial reporting practices and we realize that poor accounting practices drive out good ones.

III.   A Modified All Inclusive Concept

According to this concept, a number of subsequent pronouncements require irregular items to be highlighted so that the reader of financial statements can determine the long run earning power of the enterprise. There are five irregular items to be highlighted

• Discontinued operations
• Extraordinary items
• Unusual gains and losses
• Changes in accounting principle
• Changes in estimates

Discontinued operations

The disposal of a business or a product line is one of the most common types of irregular items. A separate category in an income statement for the gain or loss from disposal of a segment of a business must be provided. The result of operations of a segment that has been or will be disposed of is reported with the gain or loss on disposal, separately from continuing operations. The effects of discontinued operations in income statements are shown after continuing operations but before extraordinary items.

To illustrate, a company decides to discontinue its electronics division. During the current year, the electronic division loss $100,000 (net of tax) and was sold at the end of the year at a loss $160,000 (net of tax), so the total loss of discontinued operations will be $260,000 ($100,000 + $160,000). Income from continuing operations $23 million. As a result, net income on the current year’s income statement was $22,740,000 ($23 million - $260,000)

The phrase “INCOME FROM CONTINUING OPERATIONS” is only used when gains or losses on discontinued operations occur. To qualify as discontinued operations, the assets, results of operations and activities of a segment of a business must be clearly distinguishable physically and operationally from the other assets, results of operations and activities of the entity.

Disposal of assets incidental to the evolution of the entity’s business is not considered to be disposal of a segment of the business. Disposal that do not qualify as disposal of segment of a business as follow

• Disposal of part of a line of business.
• Shifting production or marketing activities for a particular line of business from one location to another.
• Phasing out of a product line or class of service.
• Other changes due to a technological improvement. 

Examples that qualify as a disposal of a segment of a business

• Sale by a meat packing company of a 60% interest in a professional football team.
• Sale by a communications company of all of its radio stations but none of its television stations or publishing houses.

 

Conversely, examples that would not qualify as a disposal of a segment of a business

• Discontinuance by a woman shoes manufacturer of its operations in Taiwan but not elsewhere.
• Sale by a diversified company of one furniture-manufacturing subsidiary but not all furniture manufacturing subsidiaries.

Judgment in defining a disposal of a segment of a business must be exercised because the criteria are difficult to apply in some cases.

Extraordinary items

Extraordinary items are events and transactions that are distinguished by their unusual nature and by the infrequency of their occurrence, or in other words it is defined as non-recurring material items that differ significantly from the entity’s typical business activities.

To classify an event or transaction as an extraordinary item, both the two following criteria must be met

a)    Unusual nature

Event or transaction should possess a high degree of abnormality and be of a type clearly unrelated to the ordinary and typical activities of the entity.

b)    Infrequency of occurrence

Event or transaction should be of a type that would not be expected to recur in the foreseeable future

According to Accounting Principle Board (APB), the following gains and losses that are not extraordinary items

(A).  Write-down or write-off of receivables, inventories, equipment leased to others,   deferred research and development (R & D) costs, other intangible assets.

(B).  Gains or losses from exchange of foreign currencies including those relating to devaluations and revaluations.

(C).   Gains or losses on disposal of a segment of a business.

(D).   Other gains or losses from sale of property, plant or equipment used in the business.

(E).    Effects of a strike, including those against competitors and suppliers.

(F).    Adjustment of accruals on long term contracts.

Those items listed above are not considered extraordinary because they are usual and may be expected to recur as a consequence of customary and continuing business activities. Gains or losses such as point (A) and point (D) above would be classified as extraordinary if they are unusual and infrequent and they do as a direct result of a major casualty such as an earthquake, an expropriation or a prohibition under a newly enacted law or regulation. Such circumstances meet the criteria of unusual and infrequent.

In determining whether an item is extraordinary, the environment of the entity operates such as

• Industry characteristics.
• Geographic location.
• The nature.
• Extent of governmental regulations

 

is primary importance. The disposal of a business segment at a gain or loss on disposal of a segment of a business, refer to point (C) above which is not an extraordinary item, requires a special accounting treatment.

Material gains and losses from extinguish of debt should be reported as an extraordinary item even though these gains or losses do not meet the normal criteria as mentioned above for extraordinary items. It is often difficult to determine what is extraordinary. Firm guidelines for judging when an item is or is not material have not been established. Some companies judge as extraordinary gains or losses items that accounted for less than 1% of income. If companies face a larger loss is inevitable, they used “big – bath” approach to write-off as much as possible because according to this approach there is not a great distinction between a small loss and a larger one, future statements will still provide a company with a quick earnings injection. Therefore, in making the materiality judgment, extraordinary items should be considered individually. These extraordinary items are to be shown net of taxes in a separate section in the income statement, usually before net income. 

A company presented its extraordinary loss in its income statement. Income before extraordinary item $12,500,000 . The extraordinary item represents the estimated cost of flood loss (net of tax) $1,306,000 (the estimated cost of flood loss $1,374,000 – tax $68,000). Therefore the net income in its income statement $11,194,000 ($12,500,000 - $1,306,000)  

Unusual gains and losses

Financial statement users must carefully examine the financial statements for items that are unusual or infrequent but not both. Items such as write-downs of inventories and gains and losses from fluctuation of foreign exchange are not considered as extraordinary items. These items are sometimes shown with the normal, recurring revenues, costs and expenses. If they are not material in amount, they are combined with other items in the income statement. However, if they are material, they must be disclosed separately, but are shown income (loss) before extraordinary items.

These $18 millions ($9 millions + $7 millions + $2 millions) are examples of unusual items, consist of

• Restructuring charges related to the company’s special voluntary early retirement program and selective job eliminations $9 millions.
• Write-off in the book group due to repositioning of inventory and promotion costs $7 millions.
• Other corporate charges $2 million

 

If company’s revenue $700 millions and operating costs and expenses $710 millions, consist of

• Production and distribution $335 millions.
• Selling and general administrative $340 millions.
• Depreciation and amortizations $17 millions.
• Unusual items as calculated above $18 millions 

Loss from operations will be $10 millions ($710 millions - $700 million) because of unusual items.

In recent years, there is a tendency to report unusual items in a separate section just above “income from operations” before income taxes and extraordinary items, especially when there are multiple unusual items. Unusual gains and losses should be reported in other revenues and gains or other expenses and losses section unless you are instructed to prepare a separate unusual items section.

In dealing with events that are either unusual or non-recurring but not both, companies often reported such transactions on a net of tax basis and prominently displayed the earnings per share effect of these items.

Changes in accounting principle

It is occur frequently in practice because important events or conditions may be difference or uncertain at the statement date. One type of accounting changes contains the rule repeating corrections and adjustments that are made by every business enterprise. Changes in accounting principle would include a change in the method of inventory pricing from FIFO to AVERAGE COST or a change in depreciation from the DOUBLE DECLINING or ACCELERATED to the STRAIGHT LINE METHOD.

Changes in accounting principle are realized by admitting the cumulative result of net income of tax in the current year’s income statement. This amount is based on a retroactive calculation of changing to a new accounting principle. The effect on net income of adopting the new accounting principle should be disclosed as a separate item following extraordinary items in the income statement.

Placement on financial statements, cumulative effect of the change is reflected in the income statement between the captions extraordinary items and net income (shown net of tax).

Changes in estimate (normal, recurring corrections and adjustments)

Estimates are built-in in accounting process. Estimates are made of

• Useful lives and salvage values of depreciable assets.
• Uncollected receivables.
• Inventory obsolescence.
• Number of periods expected to benefit from a particular expenditure.

Not in frequently, as time passes or circumstances changes or as a different information is received, however estimates originally made in straightness must be changed. Such changes in estimates are accounted for in the period of change if they affect only that period or in the period of change and future periods if the change affects both.

To illustrate a change in estimate that effects only the period of change, assume that a company has consistently estimated its bad debt expense at 1% of credit sales. However, the controller determines that the estimate of bad debts for the current year’s credit sales must be revised upward to 2% or double the prior year’s percentage. Using 2% results in a bad debt change will reduce accounts receivable to net realizable value.

The entire change in estimate is included in the current year’s income, no future periods are affected by the change. Changes in estimate are not handled retroactively. Changes in estimate are not considered errors or extraordinary items.

Changes in the realizability of receivables and inventories, changes in estimated lives of equipment and intangible assets, changes in estimated liability for warranty costs, income taxes and salary payments, are examples of changes in estimates.

Placement on financial statements, change in income statement only in the account affected, not shown net of tax.

Discontinued operations of a segment of a business is classified as a separate item in the income statement after continuing operations. The unusual, material, non-recurring items that are significantly different from the typical or customary business activities are shown in a separate section for “Extraordinary Items” below “Discontinued Operations”.

Other items of a material amount that are of an unusual or non-recurring nature and are not considered extraordinary are separately disclosed. The cumulative adjustment that occurs when a change in accounting principles develops is disclosed as a separate item just before net income.

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The Limitations of an Income Statement

As we know that financial news indicate the impact on the value of the enterprise. The statement of income called INCOME STATEMENT or STATEMENT of EARNINGS is the report that measures the success of enterprise operations for a given period of time. The business and community uses this report to determine

#   Profitability

#   Investment value

#   Credit worthiness

This report provides investors and creditors with information that helps them predict the amounts, timing and uncertainty of future cash flows.

The purposes of an income statement

The income statement helps users of the financial statement predict future cash flows in a number of different ways. Investors and creditors can use the information on the income statement to evaluate the past performance of the enterprise. Although success in the past does not mean success in the future but trends may be determined. If a reasonable correlation between past and future performance can be assumed, then predictions of future cash flows can be made.

Income statement helps users determine the risk concerned with level of uncertainty of not achieving particular cash flows among revenues, expenses, gains and losses. Operations are usually the major means by which revenues usually have greater significance then results from nonrecurring activities and events.

Suppose a manufacturing company that specializes in electronic spare-parts reported $20 million of income from continuing operations before taxes. A closer examination of this income revealed that

$8 million of income came from a gain on the sale of stock

$2.6 million represented a gain on the exchange of stock

$3.9 million came from a gain on the sale of stock in its investment portfolio

$3.4 million came from settlement of lawsuits related to patent infringements

The largest revenue $10.5 million comes from patent or royalties on its electronic spare-parts that might not continue because the patent was about to expire. Our point is that income does not tell the whole story because the derived income is at best a rough estimate, the reader of the statement should take care not to give it more significance than it deserves.

According to economists, income as the maximum value of an entity can consume during a period and still be as well off at the end as at the beginning. Any effort to measure how well an entity is at any point in time will prove fruitless unless certain assumptions are developed and applied. Income should measure not only monetary income but also physic income. Physic income is defined as a measure of increase in net wealth arising from quantitative factors. Accountants know that the recognition of such experiences might be useful but the problem of measurement has not been solved. Thus, items that cannot be reliable quantified have been discarded in determining income.

Income numbers are often affected by the accounting methods employed. For example, a company may choose to depreciate its plant assets on an accelerated basis while another company may choose a straight line basis. Assuming all factors are equal, the income of the first company will be lower than the second company event though the companies are same. Thus the quality of earnings of a given enterprise is important. Companies that use liberal or aggressive accounting policies report higher income in the short run. In such cases, we say the quality of the earnings is low. Other companies generate income in the short run as a result of a non-operating or nonrecurring event that is not sustainable over a period of time.

It is permissible to use smooth earnings by creating balance sheet reserves. This reserves are created by reducing income in good years however in less profitable years previous income is retrieved from the reserves to increase the income in the current year.  

There are two ways to calculate net income

I.  Capital Maintenance Approach or Change in Equity Approach

Ending net assets on the year minus beginning net assets on the same year plus dividend declared during the year then deduct with owner’s investments during the year, to get net income for the year.

It takes the net assets or capital values based on historical cost, discounted cash flows, current cost or fair market value and the difference in capital value at two points in time.

Suppose a corporation had beginning net assets $30,000 and $54,000 at the end of the year. During the same year additional owner’s investments $15,000 were made and $3,000 of dividends were declared. Calculation of net income for the period employing the capital maintenance approach is $12,000 ($54,000 - $30,000 + $3,000 - $15,000)

When using this capital maintenance approach, the composition of the income is not evident because the revenue and expense amounts are not presented to the financial statement reader.

II.  Transaction Approach

The alternative procedure measures the basic income related transactions that occur during a period and summarizes them in an income statement called TRANSACTION APPROACH. This approach focuses on the activities that have occurred during a given period. Instead of presenting only a net change, it discloses the components of the change. The transaction approach provides information on the elements of income. According to this approach, income may be classified by

#   Customer

#   Product line or function

#   Operating and nonoperating

#   Continuing and discontinued

#   Regular and irregular

 

It is called “IRREGULAR” if transactions and events are derived from developments outside the normal operations of the business. For example, the sale of investments by an insurance company is part of its irregular operations, whereas in a manufacturing enterprise it is not.

The transaction approach to income measurement requires the use of revenue, expense, loss and gain accounts, without which an income statement cannot be prepared. The distinction between revenues and gains and the distinction between expenses and losses depend to a great extent on the typical activities of the enterprise.

The sales of investments sold by an insurance company would generally be classified as revenue, whereas the sales price less book value on the sale of an investment by a manufacturing enterprise would be classified as gain or loss.

Single step income statement

In reporting revenues, gains, expenses and losses, many accountants prefer a format called the single step income statement. In the single step income statement, just using revenue and expenses groups. Expenses are deducted from revenue to arrive at net income or loss. Income tax is reported separately as the last item before net income to indicate their relationship to income before tax. This format of income statement is widely used in financial reporting. The primary advantage of this format lies in the simplicity of presentation and the absence of any implication that one type of revenue or expense item has priority over another.

In some cases, it is impossible to present in a single income statement of all the desired expense detail. This problem is solved by including only the totals of expense groups in the statement of income and preparing supplementary schedules of expense to support the totals. Readers who wish to study all the reported data must give their attention to the supporting schedules.

Multiple step income statement

Another format which called a multiple step income statement. Accountants use this format to describe other important revenue and expense data to make the income statement become more informative and useful. This statement is recommended because it recognizes a separation of operating transactions from non operating transactions and matches costs and expenses with related revenues. In arriving at net income, three subtotals are presented when you are using a multiple step income statement.

1. Net sales revenue
2. Gross profit
3. Income from operations

The disclosure of net sales revenue is useful because regular revenues are reported as a separated item. Irregular or incidental revenue are disclosed elsewhere in the income statement. As a result, revenue from continuing operations should be easier to understand and analyze.

Reporting of gross profit for evaluating performance and assessing future earnings. It shows how successfully a company uses its resources as a result of competitive pressure.

Disclosing income from operations highlights the difference between regular and irregular or incidental activities. This disclosure helps users recognize that incidental or irregular activities are unlikely. Disclosure of operating earnings may assist in comparing with different companies and to know operating efficiencies.

When you are using a multiple step income statement, you will find several sections and subsections there

A.  Operating section

Reporting the revenue and expenses of the company’s principal operations.

#   Sales or revenue

#   Cost of goods sole

#   Selling expenses

#   Administrative or general expenses

They are subsequents of operating section

B.  Non operating section

Reports revenues and expenses resulting from secondary or auxiliary activities of the company. Special gains and losses that are unusual or infrequent, but not both are normally reported in this section

#   Other revenue and gains from nonoperating transactions

#   Other expenses and losses

They are subsequents of nonoperating section

C.  Income tax section

A short section of reporting tax on income from continuing operations.

D.  Discontinued operations section

Material gains or losses resulting from the disposition of a segment of the business.

E.  Extraordinary items section

Unusual and infrequent material gains and losses.

F.  Earning per share section

Last section of an income statement.

The breakdown above is commonly used for manufacturing concerns and for merchandising companies in the wholesale trade. Usually financial statement that are provided to external users have less detail than internal management reports. However, whether a single step or multiple step income statement is used, irregular transactions such as

#   Discontinued operations

#   Extraordinary items

#   Cumulative effect of changes in accounting principles

They should be reported separately following income from continuing operations.

How much detail to include in the income statement is always a problem. On the one hand, we want to present a simple income statement so that a reader can discover important facts. On the other hand we want to disclose the results of all activities and to provide more than just a skeleton report. As we will see that they can be presented in various formats as long as certain basic elements are always included.

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