Jumat, 24 Juni 2011

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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