Accounting: The Language of Business (Part 86)

While one can't always begrudge the wealth of people who have at least produced something of value, the rich of the financial world don't make anything but more money. They're not creative, aside from, perhaps, in accounting.

Lionel Shriver

Income Taxes, Unusual Income Items, and Investments in Stocks (Part B)

by

Charles Lamson

Unusual Items Affecting the Income Statement

Generally accepted accounting principles require that certain unusual items be reported separately on the income statement. These items can be classified into the following two categories:

1. Those items that are reported in determining income from continuing operations, sometimes called above-the-line items.

2.  Those items that are reported as deductions from income from continuing operations, sometimes called below-the-line items.

In the following paragraphs, we discuss each of these unusual items. 

Unusual Items Affecting Income from Continuing Operations

Some unusual items are deducted from gross profit in arriving at income from continuing operations. Unusual above-the-line items consist of fixed asset impairment and restructuring changes.

Fixed Asset Impairments

A fixed asset impairment occurs when the fair value of a fixed asset falls before its book value and is not expected to recover. Examples of events that might cause an asset impairment are (1) decreases in the market price of fixed assets, (2) significant changes in the business or regulations related to fixed assets, (3) adverse conditions affecting the use of fixed assets, or (4) expected cash flow losses from using fixed assets. For example, on March 1, assume that Jones Company consolidates operations by closing a factory. As a result of the closing, plant and equipment is impaired by $750,000. The journal entry to record the impairment is as follows:

The loss on fixed asset impairment is reported as a separate expense item deducted from gross profit in determining income from continuing operations, as illustrated for Jones Company in Exhibit 2. In addition, note disclosure should describe the nature of the assets impaired and the cause of the impairment, as shown in Note A of Exhibit 2.

EXHIBIT 2 Unusual Items in Income Statement

The loss reduces the book value of the fixed asset and thus reduces the depreciation expense for future periods. If the asset could be salvaged for sale, the gain or loss on the sale would be based on the lower book value. Therefore, asset impairment accounting recognizes the loss when it is first identified, rather than at a later sale date.

Restructuring Charges

Restructuring charges are costs associated with involuntarily terminating employees, terminating contracts, or consolidating facilities, or relocating employees. Often, these events incur initial one-time costs in order to capture long-term savings. For example, involuntarily terminated employees often receive a one-time termination or severance benefit at the time of their dismissal. Employee termination benefits are normally the most significant restructuring charges; thus, they will be the focus of this section.

Employee termination benefits arise when a plan specifying the number of terminated employees, the benefit, and the benefit timing has been authorized by senior management and communicated to the employees. To illustrate, assume that the management of Jones Company communicates a plan to terminate 200 employees from the closed manufacturing plant on March 1. The plan calls for a termination benefit of $5,000 per employee. Once the plan is communicated to employees, they have the legal right to work for 60 days but may elect to leave the firm earlier. In other words, employees may be paid severance at the end of 60 days or at any time in between. The expense and liability to provide employee benefits should be recognized at its fair value on the plan communication date. The fair value of this plan would be $1,000,000 (200 * $5,000), which is the aggregate expected cost of terminating the employees. Thus, the $1,000,000 restructuring charge would be recorded as follows:

The restructuring charge is reported as a separate expense deducted from gross profit in determining income from continuing operations as shown in Exhibit 2. The employee termination obligation would be shown as a current liability. If the plan called for expected severance payments beyond one year, then a long-term liability would be recognized. In addition, a note should disclose the nature and cause of the restructuring event and the costs associated with the type of restructuring event.

The actual benefits paid to terminate employees should be debited to the liability as employees leave the firm. For example, assume that 25 employees find other employment and leave the company on March 25. The journal entry to record the severance payment to these employees would be as follows:

Unusual Items Not Affecting Income from Continuing Operations

Some unusual items are deducted from income from continuing operations and arriving at net income. Unusual items not affecting income from continuing operations consist of discontinued operations, extraordinary items, and changes in accounting principles.

Discontinued Operations

A gain or loss from disposing of a business segment or component of an entity is reported on the income statement as a gain or loss from discontinued operations. The term business segment refers to a major line of business for a company, such as a division or a department or a certain class of customer. A component of an entity is the lowest level at which the operations and cash flows can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. Examples would be a store for a retailer, a territory for a sales organization, or a product category for a consumer products company. To illustrate the disclosure, assume that Jones Corporation has separate divisions that produce electrical products, hardware supplies, and lawn equipment. Jones sells its electrical products division at a loss. As shown in Exhibit 2, this loss is deducted from Jones's income from continuing operations (income from its hardware and lawn equipment divisions). In addition, Note B discloses the identity of the segment sold, the disposal date, a description of the segment's assets and liabilities, and the manner of disposal.

Extraordinary Items

An extraordinary item results from events and transactions that (1) are significantly different (unusual) from the typical or the normal operating activities of the business and (2) occur infrequently. The gains and losses resulting from natural disasters that occur infrequently, such as floods, earthquakes, and fires, are extraordinary items. Gains or losses from condemning land or buildings for public use are also extraordinary. Such gains and losses, other than those from disposing of a business segment, should be reported in the income statement as extraordinary items, as shown in Exhibit 2.

Sometimes extraordinary items result in unusual financial results. For example, Delta Airlines once reported an extraordinary gain of over 5.5 million dollars as the result of the crash of one of its 727s. The plane that crashed was insured for $6.5 million, but its book value in Delta's accounting records was $962,000.

Gains and losses on the disposal of fixed assets are not extraordinary items. This is because (1) they are not unusual and (2) they recur from time to time in the normal operations of a business. Likewise, gains and losses from the sale of investments are usual and recurring for most businesses.

Changes in Accounting Principles

Businesses are often required to change their accounting principles when the Financial Accounting Standards Board (FASB) issues a new accounting standard. In addition, a business may voluntarily change from one generally accepted accounting principle to another. For example, a corporation may change from the FIFO [First In, First Out (FIFO) is an accounting method in which assets purchased or acquired first are disposed of first. (investopedia.com)] to the LIFO [Last in, first out (LIFO) is a method used to account for inventory. Under LIFO, the costs of the most recent products purchased (or produced) are the first to be expensed. LIFO is used only in the United States and governed by the generally accepted accounting principles (GAAP) (investopedia.com).]method of costing inventory to better match revenues and expenses. Changes in generally accepted accounting principles should be disclosed in the financial statements (or in notes to the statements) of the period in which they occur. This disclosure should include the following information: 

1. The nature of the change.

2. The justification for the change.

3. The effect on the current year's net income.

4.  The cumulative effect of the change on the net income of prior periods.

To illustrate assume that one of Jones Corporation's divisions changes from the declining-balance method (part 59) to the straight-line method (part 58) of depreciation. As shown in Exhibit 2, the cumulative effect of this change is reported after the extraordinary items. The effect on the prior period is explained in Note C. If financial statements for prior periods are also presented, they should be restated as if the change had been made in the prior periods, and the effect of the restatement should be reported either on the face of the statement or an a note.

Reporting unusual items separately on the income statement allows investors to isolate the effects of these items on income and cash flows. By reporting such items, investors and other users of the financial statements can consider such factors in assessing a business's future income and cash flows.

Reporting Unusual Below-the-Line Items

The three unusual items discussed in this section are reported separately in the income statement, below the income from the continuing operations, as shown in Exhibit 2. Many different terms and formats may be used. Unlike above-the-line unusual items, the related tax effects of below-the-line items are reported either with the item with which they are associated or in the notes to the statement.  

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 564-568*

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