CHAPTER 6

Sub chapter 2
NON-RECURRING ITEMS

Fajar Kurniawan C1I017010

Safira Amalia Chairunnisa C1I017009
 Non-Recurring Items
 

Extraordinary items

Discontinued segments

Accounting changes

Special items
 Non-Recurring Items
Extraordinary Items

Criteria
Criteria
Unusual
Unusualin
innature
nature
Infrequent
Infrequentin
inoccurrence
occurrence

Examples
Examples
Uninsured
Uninsuredlosses
lossesfrom
fromaamajor
majorcasualty
casualty(earthquake,hurricane,
(earthquake,hurricane,tornado),
tornado),losses
lossesfrom
from
expropriation,
expropriation,and
andgains
gainsand
andlosses
lossesfrom
fromearly
earlyretirement
retirementof
ofdebt
debt

Disclosure
Disclosure
Classified
Classifiedseparately
separatelyin
inincome
incomestatement
statement
 Non-Recurring Items
A b s o lu te m a g n itu d e a s a P r o p o r tio n o f C o m p a n ie s
Extraordinary Items
Frequency of Extraordinary Items
 
0.14
R e p o r tin g
0.12
0.1
Positive
0.08
Negative
0.06
Total
0.04
0.02
0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Year

Magnitude of Extraordinary Items

p e r c e n t o f S a le s

6.00%
5.00%
4.00% Positive
3.00% Negative
2.00% Total

1.00%
0.00%
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Year
 Non-Recurring Items
Extraordinary Items
 
Extraordinary
Extraordinary items:
items:
  
•• Are
Arenon-recurring
non-recurring
•• Excluded
Excludedwhen
whencomputing
computingpermanent
permanentincome
income
•• Included
Includedwhen
whencomputing
computingeconomic
economicincome
income
•• Can
Canreveal
revealrisk
riskexposures
exposures
•• Can
Canimpact
impactcomputation
computationofofsustainable
sustainableearning
earningpower
power
•• Often
OftenExcluded
Excludedwhen
whenmaking
makingcomparisons
comparisonsover
overtime
timeor
oracross
acrossfirms
firms
 Non-Recurring Items
A b s o lu te m a g n itu d e a s a P r o p o r tio n o f C o m p a n ie s
Discontinued Operations
Frequency of Discontinued Operations
 
0.1
R e p o r tin g

0.08
0.06 Positive
Negative
0.04
Total
0.02
0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Year

Magnitude of Discontinued Operations

p e r c e n t o f S a le s

6.00%
5.00%
4.00% Positive
3.00% Negative
2.00% Total

1.00%
0.00%
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Y ear
 Non-Recurring Items
Discontinued Operations

 
Accounting
Accounting is
is two-fold:
two-fold:

•• Income
Incomestatements
statementsforforthe
thecurrent
currentand
andprior
priortwo
twoyears
yearsare
arerestated
restatedafter
after
excluding
excludingthe
theeffects
effectsof
ofdiscontinued
discontinuedoperations
operations
•• Gains
Gainsor
orlosses
lossesfrom
fromthe
thediscontinued
discontinuedoperations
operationsare arereported
reportedseparately,
separately,net
netof
of
tax*
tax*
  
**Reported
Reportedinintwo
twocategories:
categories:(i)
(i)operating
operatingincome
incomeor orloss
lossfrom
fromdiscontinued
discontinuedoperations
operations
until
untilthe
themeasurement
measurementdate,
date,and
and(ii)
(ii)gains
gainsand
andlosses
losseson
ondisposal
disposal
 Non-Recurring Items
Discontinued Operations

 
For
For analysis
analysis of
of discontinued
discontinued operations:
operations:
•• Adjust
Adjustcurrent
currentandandpast
pastincome
incometo toremove
removeeffects
effectsof
ofdiscontinued
discontinuedoperations
operations
 Companies
Companiesdisclose
disclosethis
thisinfo
infofor
forthe
thecurrent
currentand
andpast
pasttwo
twoyears
years
 For
Forearlier
earlieryears:
years:

 Look
Lookforforrestated
restatedsummary
summaryinfo infoor
orother
othervoluntary
voluntarydisclosures
disclosures

 Take
Takecare
carewhen
whendoingdoinginter-temporal
inter-temporalanalysis
analysis
•• Adjust
Adjustassets
assetsand
andliabilities
liabilitiesto
toremove
removediscontinued
discontinuedoperations
operations
•• Retain
Retaincumulative
cumulativegaingainororloss
lossfrom
fromdiscontinued
discontinuedoperations
operationsininequity
equity
 Non-Recurring Items
Accounting Changes

Accounting changes are of 3 types:

 Accounting principle change
 Accounting estimate change
 Reporting entity change
 Non-Recurring Items
Accounting Changes

 
 Accounting Principle Change—involves switch from
one principle to another
 
Disclosure includes:
• Nature of and justification for change
• Effect of change on current income and earnings
per share
• Pro forma effects of retroactive application of
change on income and EPS for income statement
years
 Non-Recurring Items
Accounting Changes

Accounting Estimate Change—involves change

in estimate underlying accounting
 
• Prospective application—a change is
accounted for in current and future periods
• Disclose effects on current income and EPS
 Non-Recurring Items
Accounting Changes

Reporting Entity Change—involves initial

publication of consolidated statements, or
change in consolidation policy, or a pooling
of interest
 
• Restate all prior periods’ financial statements
and disclosing the nature of change
 Non-Recurring Items
Accounting Changes

 
Analyzing Accounting Changes
• Are cosmetic and yield no cash flows
• Can better reflect economic reality
• Can reflect earnings management (or even manipulation)
• Impact comparative analysis (apples-to-apples)
• Effect both economic and permanent income
 For permanent income, use the new method and
ignore the cumulative effect
 For economic income, evaluate the change to assess
whether it reflects reality
 Non-Recurring Items
Special Items

 
Special
Special Items
Items--transactions
--transactionsand
andevents
eventsthat
thatare
areunusual
unusualor
orinfrequent
infrequent
  
Challenges
Challengesfor
foranalysis
analysis


 Often
Oftenlittle
littleGAAP
GAAPguidance
guidance

 Economic
Economicimplications
implicationsare
arecomplex
complex

 Discretionary
Discretionarynature
natureserves
servesearnings
earningsmanagement
managementaims
aims
  
Two
Twomajor
majortypes
types


 Asset
Assetimpairments
impairments(write-offs)
(write-offs)

 Restructuring
Restructuringcharges
charges
 Non-Recurring Items
Special Items

  Frequency of Special Items

Proportion of Companies
0.5
0.4
Reporting

0.3 Positive
Negative
0.2
Total
0.1
0
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Year
 Non-Recurring Items
Special Items

Magnitude of Special Items

 

6.00%
Absolute magnitude as a

5.00%
percent of Sales

4.00% Positive
3.00% Negative
2.00% Total

1.00%
0.00%
83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01
Year
 Non-Recurring Items
Break-Up One-Time Charges (Special Items)

  One-Time Charges by Frequency

Ot he r Goodwill
5% 11%

Re st r uc t ur ing
22%

P P &E
19%

Unide nt if ia ble Inve nt or y

27% 16%
 Non-Recurring Items
Break-Up One-Time Charges (Special Items)

One-Time Charges by Amount ($)

 
Other Goodwill
8% 8%

Restructuring PP&E
31% 32%

Inventory
Unidentifiable 2%
19%
 Non-Recurring Items
Special Items

 
Asset
Asset Impairment—when
Impairment—whenasset assetfair
fairvalue
valueisisbelow
belowcarrying
carrying(book)
(book)value
value
  
Some
Somereasons
reasonsfor forimpairments
impairments
Decline
Declineinindemand
demandfor forasset
assetoutput
output
Technological
Technologicalobsolescence
obsolescence
Changes
Changesinincompany
companystrategy
strategy
  
Accounting
Accountingfor forimpairments
impairments
Report
Reportat atthe
thelower
lowerof
ofmarket
marketor orcost
cost
No
Nodisclosure
disclosureabout
aboutdetermination
determinationof ofamount
amount
No
Nodisclosure
disclosureabout
aboutprobable
probableimpairments
impairments
Flexibility
Flexibilityinindetermining
determiningwhen
whenand andhow
howmuch
muchto towrite-off
write-off
No
Noplan
planrequired
requiredforforasset
assetdisposal
disposal
Conservative
Conservativepresentation
presentationofofassets
assets
 Non-Recurring Items
Special Items

 
Restructuring
RestructuringCharges—costs
Charges—costsusually usuallyrelated
relatedtotomajor
majorchanges
changesinincompany
companybusiness
business
  
Examples
Examplesof ofthese
thesemajor
majorchanges
changesinclude
include
Extensive
Extensivereorganization
reorganization
Divesting
Divestingbusiness
businessunits
units
Terminating
Terminatingcontracts
contractsand
andjoint
jointventures
ventures
Discontinuing
Discontinuingproduct
productlines
lines
Worker
Workerretrenchment
retrenchment
Management
Managementturnover
turnover
Write-offs
Write-offscombined
combinedwithwithinvestments
investmentsininassets,
assets,technology
technologyor
ormanpower
manpower
  
Accounting
Accountingforforestimated
estimatedcosts
costsof ofrestructuring
restructuringprogram
program
Establish
Establishaaprovision
provision(liability)
(liability)for
forestimated
estimatedcosts
costs
Charge
Chargeestimated
estimatedcosts
coststo tocurrent
currentincome
income
Actual
Actualcosts
costsinvolve
involveadjustments
adjustmentsagainst
againstthe
theprovision
provisionwhen
whenincurred
incurred
 Non-Recurring Items
Special Items

Analyzing
Analyzingspecial
specialitems
itemsisischallenging
challengingand
and
important
important
Challenges
Challengesarise
arisefrom
fromlack
lackofofguidance
guidancein
in
accounting
accountingstandards
standards
Challenges
Challengesalso
alsoarise
arisein
inunderstanding
understandingthethe
economics
economicsofofspecial
specialitems
items
Importance
Importancerelates
relatesto
tothe
thefrequency
frequencyand
andimpact
impact
on
onpast,
past,present,
present,and
andfuture
futureincome
income
 Non-Recurring Items
Special Items

Earnings Management with Special Charges

(1)  Special charges often garner less investor

attention under an assumption they are non-recurring
and do not persist

(2)  Managers motivated to re-classify operating

charges as special one-time charges

(3) When analysts ignore such re-classified charges

it leads to low operating expense estimates and
overestimates of company value
 Non-Recurring Items
Special Items

  Earnings Management with Special Charges—An Illustration

• Company earns $2 per share in perpetuity
• Cost of capital is 10%
• Company valuation is $20 ($2/0.10)
• Company overstates recurring earnings by $1 per share for 4 periods and then reverses this with a single charge in the fourth year:

($ per share) Year 1 Year 2 Year 3 Year 4

Recurring earnings $2 + $1 $2 + $1 $2 + $1 $2 + $1
Special charge -- -- -- (4)
Net Income $3 $3 $3 $(1)

Analysis
(1) Suggests permanent component of $3 per share and a transitory component of $(4) per share in Year 4
(2) Company stock is valued at $26 ([$3 / 0.10] - $4)
(3) Ignoring special charges (as some analysts advise) yields stock valued at $30 ($3 /0.10)
 Non-Recurring Items
Special Items

 
Earnings
EarningsManagement
Managementwith
withSpecial
SpecialCharges—Graphical
Charges—GraphicalIllustration
Illustration
20
E a rn in g s p e r S h a re ($ )

10

-10

-20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
Year
 Non-Recurring Items
Special Items

Income Statement Adjustments

 
(1) Permanent income reflect profitability of a company
under normal circumstances
• Most special charges constitute operating expenses
that need to be reflected in permanent income
• Special charges often reflect either understatements
of past expenses or investments for future profitability
 
(2) Economic income reflects the effects on equity of all
events that occur in the period
• Entire amount of special charges is included
 Non-Recurring Items
Special Items

Balance Sheet Adjustments

Balance sheets after special charges often better reflect
business reality by reporting assets closer to net realizable
values
 
Two additional points
(1) Retain provision or net against equity?
• If a going-concern analysis, then retain
• If a liquidating value analysis, then offset against equity
 
(2) Asset write-offs conservatively distort asset and liability
values
THE END