Extraordinary and Non-Recurring Items on Income Statements
What are non-recurring and extraordinary items or events on the income statement? 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. It depends on what's going on in the world and the specific business.
Understanding Non-Recurring Expenses
Imagine you own a successful dry cleaning business. Out of the blue, a tornado sweeps away your storefront, destroying the building that houses your business plus many of the buildings in the commercial district of the small town where 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 ongoing cost 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.
Separating the One-Time Event From the Ongoing
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.
By differentiating non-recurring and extraordinary events, investors can predict future earnings more accurately.
Say 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.
How Non-Recurring and Extraordinary Events Differ
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 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 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.