Extraordinary Items Share Exclusive Company

Only unusual and infrequent events pass muster under FASB 145.

by Theresa F. Henry and Mark P. Holtzman

EXECUTIVE SUMMARY

Material gains and losses are classified as “extraordinary” on the income statement when they are both “unusual” and “infrequent.” Extraordinary items are reported at the bottom of the income statement, net of their tax effects. FASB Statement no. 145 significantly shortened the list of extraordinary items by repealing the requirement that all early extinguishment of debt be treated as extraordinary. This eliminated most gains and losses previously treated as extraordinary items. Whether an event is unusual depends on the environment in which the entity operates, taking into account factors such as the characteristics of the industry or industries in which it operates, the geographical location of its operations, and the nature and extent of governmental regulation. The past occurrence of an event or transaction provides some evidence of the probability of recurrence of that type of event or transaction in the foreseeable future in determining whether the occurrence is sufficiently infrequent. Theresa F. Henry, CPA, Ph.D., is an assistant professor of accounting and taxation at Seton Hall University, Stillman School of Business. Mark P. Holtzman, CPA, Ph.D., is an assistant professor of accounting and taxation at Seton Hall University, Stillman School of Business. Their e-mail addresses are henrythe@shu.edu and holtzmma@shu.edu, respectively.

he extraordinary item still appears on some companies’ income statements, but it’s much less common than it used to be, largely because of FASB Statement no.145, introduced in 2002. This continued a trend among standard-setters toward more restrictive criteria for which items can be classified as extraordinary.

Material gains and losses are classified as extraordinary on the income statement only when they are unusual and infrequent. Extraordinary items are reported at the bottom of the income statement, net of their income tax effects.

The following study surveys more than 16,000 public companies’ financial statements, measuring the frequency of extraordinary items and identifying specific types of gains and losses that have recently been reported as extraordinary. This article will help practitioners detect gains and losses that may fit within the narrow definition of extraordinary items.

THE EXTRAORDINARY ITEM CLUB
Statement no. 145 significantly shortened the list of extraordinary items by repealing the requirement of Statement no. 4, Reporting Gains and Losses From Extinguishment of Debt, that early extinguishment of debt be treated as extraordinary. By 2004, Accounting Trends and Techniques found just 4 items reported (out of 600 companies surveyed). Of the 78 extraordinary items reported in 2001, all but eight related to the early extinguishment of debt.

Our more extensive survey of 16,000 companies indicates less than 0.2% of publicly traded companies reported extraordinary items in 2004.

SELECTIVITY KEEPS THE CLUB EXCLUSIVE
APB Opinion no. 9, Reporting the Results of Operations, issued in 1966, defined extraordinary items as those “of an extraordinary nature and whose effects are material.” Examples included disposal of a plant (or a significant segment of the business), sale of an investment not acquired for resale, write-off of goodwill, expropriation of properties and major devaluation of a foreign currency.

In 1973, APB Opinion no. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, tightened the criteria, so that to be classified as extraordinary, an event or transaction must be both unusual and infrequent.

What is “unusual?” To determine an entity’s ordinary and typical activities, one must consider the specific characteristics of the entity, such as the type and scope of operations, lines of business and operating policies and environment. The environment includes factors such as industry or industries in which it operates, its geographical location, and the nature and extent of governmental regulation. Thus, according to APB Opinion no. 30, an event or transaction may be unusual for one entity but not for another.

What is “infrequent?” According to the opinion, an infrequent event or transaction is one that is not reasonably expected to recur in the foreseeable future. Because this determination also depends on the environment in which an entity operates, what is extraordinary for one entity may not be for another. The past occurrence of an event or transaction provides some evidence of the probability of recurrence of that type of event or transaction in the foreseeable future.

The opinion identifies the following gains and losses not considered extraordinary:

Write-down or write-off of receivables, inventories, equipment leased to others, deferred research and development costs, or other intangible assets.

Gains or losses from exchange or translation of foreign currencies, including those relating to major devaluations and revaluations.

Gains or losses on disposals of a segment of a business.

Other gains or losses resulting from sale or abandonment of property, plant and equipment used in the business.

Effects of a strike, including those against competitors and major suppliers.

Adjustment of accruals on long-term contracts.

» Practical Tips

Properly reporting nonrecurring gains and losses as extraordinary items will help financial statement users exclude the effects of unusual and infrequent items when evaluating a company’s operations. FASB Statement no. 145 did not completely eliminate extraordinary treatment for material gains and losses from early extinguishment of debt. It eliminated the FASB Statement no. 4 requirement that all such gains and losses be treated as extraordinary. Early extinguishment of debt still may be an extraordinary item if its occurrence is unusual and infrequent under FASB Statement no. 145 and APB Opinion no. 30.

Companies should disclose the nature and financial effects of each event or transaction on the face of the income statement or in notes to the financial statements.

FASB’s guidance in EITF 01-10 specifies that costs and losses associated with the terror events of Sept. 11, 2001, should be classified as part of income from continuing operations. The Task Force concluded these events were so wide-ranging and pervasive that extraordinary item treatment would not effectively communicate their financial effects. The EITF did not provide accounting guidance for the effects of Hurricane Katrina. In practice, then, the EITF eliminated both acts of terror and most natural disasters from the repertoire of extraordinary events. AICPA’s Technical Practice Aid 5400.05, Accounting and Disclosure Guidance for Losses From Natural Disaster—Nongovernmental Entities, provides further guidance on how to treat such losses.

MEET THE MEMBERS
We searched the Compustat database, which includes the financial statements of 16,378 publicly traded companies, for extraordinary gains and losses. For 2004, the most recent year available, we found just 27 companies, or 0.16% of the total, reporting extraordinary items.

The most common extraordinary item was negative goodwill (11 companies or 41% of the total number of extraordinary items reported). In a business combination, if the fair value of the net assets acquired exceeds the cost of the acquired entity, the difference would be recorded as an extraordinary gain under FASB Statement no. 141.

The next most common item resulted from early extinguishment of debt, reported by just five companies (19% of those reporting extraordinary items). As noted, Statement no. 145 did not completely eliminate extraordinary treatment for material gains and losses from early extinguishment of debt. It eliminated the former Statement no. 4 requirement that all such gains and losses be treated as extraordinary items. Under Statement no. 145, as under APB Opinion no. 30, such items must be unusual and infrequent to receive extraordinary treatment (see Exhibit 1). One other company originally reported an extraordinary gain on extinguishment of debt in 2004 but later amended its income statement to change this classification.

Disclosure Example Extraordinary Item: Early Extinguishment of Debt During 1989, the Company acquired from Competitive Technologies Inc. (“Competitive”) substantially all of the assets that comprise the Company’s business through an Asset Purchase Agreement. The purchase price was $6,000,000 to be paid with $500,000 down and $250,000 per year, increasing at a rate of five percent per year. The Company recorded the assets and the obligation net of imputed interest. The Company defaulted on the obligation to Competitive and during 1994 the Company entered into negotiations with them for relief with respect to the note payable. As a result of pending litigation instituted during August 2003, in October 2003 the Company and Competitive entered into a settlement agreement in connection with this debt. Under the terms of the settlement agreement, all prior obligations of the Company have been irrevocably terminated in exchange for a $1,250,000 non-interest-bearing installment note, secured by the assets of the Company subordinate only to the security interest granted to UNIINVEST Holding AG (Note 7). The settlement calls for a $100,000 payment on the signing of the agreement (paid) and quarterly payments beginning on December 31, 2003, for the greater of (i) $100,000 or (ii) an amount equal to 50 percent of the royalties received by the Company from Bausch & Lomb during the quarter ending on the payment due date. On the date of the settlement agreement, the Company recognized a one-time extraordinary gain of approximately $1,952,000 which is net of associated expenses and applicable income taxes of $1,178,050. At June 30, 2004, the Company owed $838,139 on this note. Unilens Vision Inc.: Form 20-F, FYE 6/30/04, p. 46.

Four companies (15%) reported extraordinary gains or losses from discontinuance of regulatory accounting. When an entity no longer uses FASB Statement no. 71, Accounting for the Effects of Certain Types of Regulation, the resulting gains and losses should be treated as extraordinary under FASB Statement no. 101. This could happen when there is deregulation or a change in the regulation method or competitive environment for the enterprise’s regulated services or products. The gain or loss would result from eliminating assets and liabilities (under Statement no. 71) from the balance sheet.

Three companies (11%) reported extraordinary gains or losses from first-time consolidation of variable-interest entities. When consolidating a variable-interest entity for the first time, under FASB Interpretation no. 46R, one must record an extraordinary loss, in lieu of goodwill, if the entity is not defined as a business. As with typical consolidations under Statement no. 141, companies incurring negative goodwill on a first-time consolidation of a variable-interest entity will record an extraordinary gain.

One company reported an extraordinary gain on involuntary conversion of assets due to a fire (see Exhibit 2). Two more companies had reported extraordinary items for involuntary conversion of assets due to hurricanes but subsequently amended their income statements to account for this event as an unusual, but not extraordinary, item. Because hurricane losses do not generally meet the criteria of unusual and infrequent, companies have not reported these losses as extraordinary. Six hurricanes, not classified as extraordinary in 2004, would indicate that hurricane losses do not meet the criteria as unusual or infrequent. (See AICPA Technical Practice Aid 5400.05.)

Disclosure Example Extraordinary Item: Fire On March 28, 2003, the Company had an accidental fire at the Junction, Texas, plant. The Company was given permission to begin demolition and the rebuilding of a portion of the production facility in April 2003. The initial restoration project, completed in May 2003, included the rebuild of one extrusion line that had been partially damaged, electrical system replacement and roof replacement. The rebuild of the second extrusion line was completed in April 2004. The Junction plant is fully insured for fire damage and business interruption. Through December 31, 2004 and 2003, the Company had received $6.0 million and $5.4 million, respectively, in insurance proceeds related to this incident. Due to the Junction facility fire, gross assets were written down by approximately $4.91 million, along with the associated accumulated depreciation on those assets in the amount of $3.96 million, resulting in a net book value decrease in assets of about $950,000. At December 31, 2004 and 2003, approximately $6.4 million and $3.9 million, respectively, had been invested in reconstructing the Junction facility. Insurance proceeds received to reimburse costs incurred to reconstruct the facility resulted in gains of $173,536 and $2,962,041 for the years ended December 31, 2004 and 2003, respectively. Additionally, the Company recorded $11,213 in business interruption insurance during 2004, including $8,720 to replace lost income and $2,493 to cover fixed expenses. During 2003, the Company recorded $1,366,682 in business interruptions insurance, including $1,125,372 to replace lost income and $241,310 to cover fixed expenses. At December 31, 2003, approximately $484,000 was included in accounts receivable for expected insurance reimbursements. AERTA, Inc.: Form 10-K, FYE 12/31/04, p. F-24.

The remaining three items include: write-up of a regulatory asset, a change in a retirement fund, and receipt of escrow moneys from bankruptcy. Two other companies that had originally reported extraordinary items (one for reverse merger and one for litigation) later amended their income statements to change this classification.

IS IT EXTRAORDINARY?
In evaluating whether an event or transaction is extraordinary, CPAs should look to the guidance of standards outlined in this article and common practice. Our survey of common practice indicates that few gains and losses on early extinguishment of debt meet the criteria of being unusual and infrequent. Furthermore, most hurricane and fire damage is not reported as extraordinary. This leaves few transactions that are sufficiently unusual and infrequent to join one of accounting’s most exclusive clubs.