When you evaluate the financial statements of a company, one of the common things you get to see is the presence of extraordinary items or exceptional items. As the names suggests, these are transactions that occur outside the normal course of the operations of the company. They need to be reported separately so that they can be excluded for a lot of analytical purposes. For example, if a steel company has reported a 100% growth in profits and the entire growth is coming from the sale of investments, then you can distort your view on growth by considering these items. Hence they need to be excluded from calculations. Let us look at unusual or infrequent items income statement and assess how they impact the profitability and the growth guidance. Let us also look at the effects of unusual or irregular items on financial statements. Let us also look at the impact with examples of extraordinary items on financial statements.
What do we understand by exceptional and extraordinary items?
Let us begin by looking at exceptional items as a transaction that is not in the normal course of business. An extraordinary item can be a source of income or expense. Hence, an extraordinary item can either enhance the profits or can reduce the profits. These exceptional items assume significance from the perspective of Schedule VI of Companies Act, 1956; Schedule III of Companies Act, 2013, and clause 41 [1] of listing agreement. All listed companies with significant exceptional items have to report to the reasons to the stock exchange. This is necessitated if the exceptional is more than Rs.10 lakhs or more than 10% of profits.
Why to sequester extraordinary and exceptional items?
Extraordinary items are specified as allowed to be excluded from net income if the inclusion would cause users to draw misleading conclusions from an analysis of net income. What does extraordinary items normally consist of?
It includes amounts of a non-recurring nature specifically related to prior years’ operations, such as eliminating previously established retained earnings reserves or adjusting past income taxes.
Exceptional items also include any amounts resulting from unusual sales of assets not of the type in which the company commonly deals like a steel company selling some of its assets and machinery.
Losses from disasters not commonly insured against (e.g., wars, riots, and earthquakes), assuming that such losses are not routine losses as in the case of oil rigs, high risk manufacturing facilities etc.
Exceptional losses from writing off intangibles, such as goodwill or trademarks; Un-amortized bond discounts, bond premiums, or bond issue expenses when the related debt is retired or refunded before maturity.
Some instances of specific extraordinary items
The accounting standards define some of the key exceptional items as follows:
The write down of inventories to net realizable value
Disposal of items of fixed assets
Disposal of long term investments
Legislative changes having retrospective application like increase in dearness allowance with retrospective effect
Litigation Settlement.
Here is what you need to remember about exceptional items. Firstly, such items are not expected to recur in the future. Secondly, the nature and amount of such item is significant and hence it is relevant to financial statement. Thirdly, they are generally disclosed to balance sheet.
Importance of separate disclosure of exceptional items
Why do the accounting standards insist on separate disclosure of such exceptional or extraordinary items. One of the important objectives of disclosure of financial performance is to be of predictive value and such exceptional items being non-recurring in nature take away the predictive value. Also, such inflows and outflows are not exactly of analytical value and do not pertain to the core business of the company. Exceptional items not being repetitive in nature do not have a predictive value. Extra ordinary items are anyway not a part of the operations of the company, and therefore, cannot be expected to recur. Hence, the objective of a separate disclosure is to let the reader take a view on expected future performance of the company. Most analysts exclude the impact of extraordinary and exceptional items so that a better picture of the profitability and margins of the company can be gauged.