Unusual Income Statement Items

Users of financial statements are extremely interested in the periodic earnings reported by a company. Current net income influences the amount of dividends to be distributed as well as the market price of the stock. In addition, current net income is a starting point for predicting future income. For these reasons, the income statement is presented in a way that enhances usefulness to investors, creditors, and other users of financial statements.

To achieve this goal, the accounting profession requires that business income from the recurring activities of a company be segregated from income produced by unusual and uncommon transactions and events, making it easier for users to evaluate the performance of a company and to predict future income.

In predicting future income, it is the performance of recurring activities of a company that is important, not the results of transactions or events that are not expected to recur. Three of the more frequently encountered unusual items are:

1. discontinued operations,
2. extraordinary items, and
3. changes in accounting principle.

Discontinued Operations

The term discontinued operations refers to operations of a segment of a company that has been sold, abandoned, spun off, or otherwise disposed of. A segment is a component whose activities represent a separate major line of business or class of customer. It may be a subsidiary, a division, or a department, as long as its activities can be clearly distinguished from other activities, both physically and operationally, for financial reporting purposes.

The income or loss of the discontinued operation is reported separately. This item appears on the income statement after a subtotal amount called income from continuing operations. Income from continuing operations is the income after taxes of the recurring operations of the company. The effect of this requirement is to separate the revenues, expenses, gains, and losses of discontinued operations from those of continuing operations.

The gain or loss from discontinued operations is computed by adding the segment's net income or loss for the period and the gain or loss on disposal of the segment net of income taxes.

Extraordinary Items

Material gains and losses that result from unusual events or transactions are referred to as extraordinary items. These transactions are reported separately from the effects of continuing operations and appear directly below discontinued operations on the income statement net of income taxes. They are separated from continuing operations because, by definition, they are not expected to recur.

To be classified as an extraordinary item, a transaction or event must be both unusual and infrequent. Notice that both criteria must be satisfied. A transaction or event is considered unusual if it possesses a high degree of abnormality and is unrelated to the ordinary and typical activities of a company.

In deciding if an event is in fact extraordinary, consideration must be given to the environment in which a company operates, taking into account factors such as industry characteristics, geographical location of facilities, and the extent of government regulation. Thus, earthquake damage in New York might qualify as extraordinary, whereas such damage in California might not.

The second criterion that must be met concerns frequency of occurrence. If an event or transaction occurs every five or ten years, it does not qualify as infrequent.

A good example of an extraordinary loss is a $36 million loss recognized by Weyerhaeuser Company as a result of volcanic activity at Mount St. Helens. Explosively driven debris and boiling mud spewing from the volcano covered 68,000 acres owned by Weyerhaeuser and destroyed valuable timber.

Change in Accounting Principle

To enhance the comparability of financial statements from year to year, companies are expected to follow the same accounting methods or principles from one period to the next. Otherwise, it would be nearly impossible to evaluate the progress of the company by examining its financial statements.

Although the accounting profession advocates consistency, a company may change accounting methods if management can justify the change and its auditors concur. If new methods are adopted, the effects must be clearly disclosed in the income statement. Examples of changes include a switch in depreciation methods (e.g., from double-declining balance to straight-line depreciation) and a change in inventory costing (e.g., from weighted-average to FIFO).

When a company changes its accounting methods and practices, it must compute the difference in the total net income reported in prior years and the income that would have been reported over the same period under the new principle.

For example, assume that Athena Corporation has decided to switch from recording depreciation by the double-declining balance method to using straight-line depreciation. Assume that if the latter had been used in previous years, net income would have been $75,000 greater. This increase must be reported at the bottom of the income statement and described as cumulative effect on prior years of a change in depreciation method -- $75,000. Note that these items should be presented net of income taxes.

Stockholders' Equity

Stockholders' equity is defined by SFAC No. 6 as "the residual interest in the assets of an entity that remains after deducting its liabilities." This term is the mathematical difference between total assets and total liabilities on the balance sheet.

The balance in stockholders' equity will depend upon the measurement of a company's individual assets and liabilities. Stockholders' equity will change each period by the amount of net income earned that period after adjusting for additional investments or distributions by owners.

The complexity of capital stock agreements, various legal restrictions, and actions of the board of directors make this section of the balance sheet particularly complex to prepare and understand. Stockholders' equity usually includes the following components:

• Capital Stock. Capital stock is recorded at the par or stated value of the shares issued. Capital stock is the general term that includes both common stock and preferred stock. Common stockholders are the owners of a company and have claim to all the assets after all liabilities and preferred stock claims have been satisfied in liquidation. In addition, common stockholders elect the members of a company's board of directors to manage the affairs of the business in their absence. Preferred stock has several features similar to debt and carries a limited claim on assets in the event a company is dissolved. Preferred stock usually does not carry a voting privilege but does receive preference over common stock on dividend distributions and claims on assets in the event the company is liquidated.

• Additional Paid-In Capital. Additional paid-in capital is primarily the amount received in excess of the par or stated value of the shares sold. Par value has no significance with respect to common stock and provides no indication of the market value of the stock. Generally, it is an arbitrarily assigned amount determined when the corporation was originally organized. The amount of par value reported on the balance sheet is the par value of the stock multiplied by the number of shares issued. Any difference between par value and the amount received from the sale of the stock is recorded as additional paid-in capital.

• Retained Earnings. Retained earnings consist of the undistributed profits or earnings of a company. These earnings have been retained for use by a company rather than distributed to the stockholders as dividends. A financial statement generally called the statement of retained earnings (in the case of Office Depot, the statement is titled Consolidated Statements of Stockholders' Equity) is a part of the financial statement package that includes the income statement, balance sheet, and statement of cash flows. The statement of retained earnings explains any changes in the balance of the retained earnings account during the accounting period and relates the income statement to the balance sheet. Note that most public companies include the statement of retained earnings as an element of the statement of stockholders' equity.  

• Comprehensive Income. Generally, all revenues, expenses, and gains and losses during an accounting period are included in income. However, the FASB has allowed certain unrealized gains and losses to bypass income and appear as a separate line in the stockholders' equity section of the balance sheet. Examples include unrealized gains and losses on available-for-sale securities and translation gains and losses on foreign currency.

The FASB became increasingly concerned that users of financial statements might ignore these gains and losses if they appear on the balance sheet and not on the income statement. Consequently, the FASB now requires that certain unrealized gains and losses (including the examples cited in the previous paragraph) bypassing the income statement be reported in a new category called "other comprehensive income."

Companies are permitted to display the components of other comprehensive income in one of three ways:

1. Append it to the bottom of the income statement.
2. Present a separate statement of other comprehensive income.
3. Include it in the statement of changes in stockholders' equity.

Each format requires that net income must be added to other comprehensive income to produce comprehensive income. Earnings per share information for comprehensive income is not required.