In the previous two posts we covered the various aspects of recognizing revenue and recognizing expenses on the income statement and the various methods that can be employed for calculating revenue or expense in a particular accounting period. In this post we will move our discussion forward to learn about the treatment of non recurring items and the effect of changes in accounting policies on the income statement.
Non recurring items on the income statement
Some items on the income statement do not occur in all accounting periods year after year. They are called non recurring items. For example, sale of plant and machinery. Such items can either inflate or deflate the net earnings of the company in the accounting period in which they are reported. Since such increase or decrease in net earnings is most likely a one-time phenomenon and is not expected occur again in the near future, it is prudent to exclude the effect of such non recurring items while analyzing the income statement of a company and forecasting future earnings. Below we will examine some types of non recurring items.
Discontinued operations are those which a company either plans to dispose off or has disposed off in the current accounting period. To be classified as discontinued operations, the discontinued component should be physically and operationally distinct from the rest of the company. Income or loss from discontinued operations (net of tax) is reported in the income statement separately, after net income from continuing operations and forms a part of the overall net income of the company in the particular accounting period. See the income statement example covered in a previous post or refer to the info graphic below.
Since income or loss from discontinued operations is a non recurring item it should be excluded from future earnings forecast.
Extraordinary items are those items on an income statement that are both unusual and infrequent. For example, uninsured losses from natural disasters that are not expected to reoccur in the near future.
Extraordinary items are presented on the income statement net of tax, below income from discontinued operations and are part of overall net income of the company. Again the effect of extraordinary items should be excluded while forecasting future earnings.
Unusual or infrequent items
Unusual or infrequent items are just that, either unusual or infrequent, but not both. Items that do not meet the criteria of extraordinary items are classified as unusual or infrequent and are reported before tax on the income statement as a part of the company’s income from continuing operations. For example, sale of an asset.
Like other non recurring items the effect of unusual or infrequent items should be excluded from future earnings forecasts.
Changes in accounting policies
Accounting policies are sometimes changed to better reflect the company’s financial performance. Changes in accounting policies include changes in accounting principles, changes in accounting estimates and prior period adjustments.
Accounting principles followed may sometimes undergo a change. For example, the inventory valuation method that the company follows may be changed from FIFO to LIFO or the depreciation expense method may be changed from straight line to accelerated depreciation. Changes in accounting principles are required to be applied retrospectively so that the financial statements are comparable over time. The footnotes are required to describe such changes and provide justification for them.
Similarly, accounting estimates are sometimes restated. For example, the estimated useful life of an asset may be restated on reassessment. Such changes are applied prospectively and do not require prior financial statements to be restated. Significant changes should be disclosed in the footnotes.
Prior period adjustments include correction of an error made in accounting in a prior period. Financial statements for all prior periods included in the current financial statements are required to be restated. Footnotes are required to disclose such errors.
That’s all in this post…in this post we covered the treatment of non recurring items and accounting policy changes…hope you liked reading it and won’t hesitate to share it…do tell me if u did…I’d love to hear from you..i have embedded a short ppt covering the post below…you can use it as a reference…
in the next two posts well we will cover earnings per share and its calculation under a simple capital structure and a complex capital structure and common size income statements…so stay tuned…
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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