Extraordinary or Nonrecurring Items on Income Statements
What are non-recurring and extraordinary items or events on the income statement? Depending upon what is going on in the world, and the specific business you are analyzing, this particular line item can be entirely absent, perhaps for years at a time, and then record windfall profits or losses that have wide-reaching implications for the enterprise. An illustration will help you understand how and why they arise.
Imagine that you own a successful dry cleaning business. Out of the blue, a tornado sweeps away your storefront, destroying not only the building in which your business was located but many of the buildings in the commercial district of the small town in which you operate. You're shut down for months as debris is removed and construction crews come in to rebuild, paid by insurance proceeds. When you prepare the financial statements for your business at the end of the year, does the tornado represent an on-going cost that you must regularly pay the same way you have to cover supplies, electricity, and employee compensation? Of course not. It was a freak accident most likely not to occur again.
We live in an unpredictable world. Whether in life or business, events will arise that are not expected and most likely not occur again (at least anytime soon). These one-time events are separated on the income statement and classified as either non-recurring or extraordinary. There is a difference between the two, which we'll explain in a moment.
By differentiating these two categories, it allows investors to predict future owner earnings more accurately. By way of illustration, if you were considering purchasing a gas station, you would base your valuation on the earning power of the business — how much gasoline you could sell, how many cups of coffee you could sell, how many Hershey bars you could sell — ignoring one-time costs such as replacing the station's windows after a thunderstorm. Likewise, if the owner of the station had sold a vintage Coke machine for $17,000 the year before, you would not include it in your valuation because you had no reason to expect that profit would be realized again in the future. Once sold, there are no more vintage Coke machines you can sell to generate cash for you.
The Difference Between Non-Recurring and Extraordinary Events on the Income Statement
What is the difference between non-recurring and extraordinary events? The answer is simple.
- Non-Recurring Event: A non-recurring event is a one-time charge that the company doesn't expect to encounter again.
- Extraordinary Event: An extraordinary item is an event that materially* affected a company's finances and needs to be thoroughly explained in the annual report or Form 10-K filing. Extraordinary events can include costs associated with a merger or the expense of implementing a new production system. An illustration from the annals of corporate history would be McDonald's implementation of the Made For You food preparation system in the late 1990s, which cost millions of dollars.
There is an important distinction between the two categories that you should never forget: Non-recurring items are recorded under operating expenses, while extraordinary items are listed after the net line, after-tax. Read that part again. It is of the utmost importance if you want to understand how to read an income statement correctly.
* The term "material" is not specific. It generally refers to anything that affects a company in a meaningful and significant way. Some investors try to put a number on the figure, saying an event is material if it causes a change of 5% or more in the company's finances.