Non-recuring Items and Changes in Accounting Policies

When assessing a company’s possible future performance, it is advisable to separate recurring and non-recurring items. Recurring items are items of income and expense likely to continue in the future, while non-recurring items (such as discontinued operations and unusual or infrequent items) are less likely to continue.

The effects of changes in accounting policies should also be considered when assessing a company’s possible future performance. Changes in accounting policies can materially change how information is presented in the financial statements.

Other items that may be reported separately include unusual items, items that occur infrequently, and non-operating income.

Discontinued Operations

Under IFRS and US GAAP, a company must separately report the impact of discontinued operations on its income statement. Discontinued operations refer to parts of the business that the company has either already disposed of or plans to dispose of, with no future involvement expected.

Discontinued operations are considered separate both physically and operationally, and their results are presented at the bottom of the income statement on a net basis, including per share figures. The other sections of the income statement, such as revenue, cost of goods sold, and earnings per share from the ongoing businesses, represent the outcomes of continuing operations and are reported accordingly.

On the balance sheet, assets and liabilities associated with the discontinued operations are grouped and listed as held for sale. This distinction allows analysts to more clearly assess the financial performance of continuing versus discontinued operations. Since discontinued operations will no longer contribute to the company’s earnings or cash flow after their disposal, analysts may exclude them when projecting the company’s future financial performance after a specific date.

Unusual or Infrequent Items

Since December 15, 2015, US GAAP has mandated that items of a material nature that are either unusual or infrequent, or both, should be distinctly presented within a company’s continuing operations. An example of such an item is the expenses related to a company’s restructuring, such as plant closure costs and employee severance payments.

IFRS also emphasizes the importance of separately disclosing items that are significant or essential for understanding an entity’s financial performance. Items that are unusual or infrequent are likely to fit these criteria. For instance, gains or losses from the sale of assets or business segments at a value different from their book value are disclosed separately on the income statement, as these transactions are considered part of regular business activities.

Highlighting the unusual or infrequent nature of these items aids analysts in evaluating the probability of their recurrence, aligning with the IFRS requirement to disclose items that are pertinent to understanding an entity’s financial performance.

In forecasting future operations, analysts should consider whether the reported items are likely to reoccur and their potential impact on future earnings. It is generally not recommended to simply overlook all unusual items.

Changes in Accounting Policies

Companies may need to change accounting policies due to new standards issued by standard setters. These changes can be applied either prospectively, meaning for future periods, or retrospectively, meaning restating financial statements as though the new policy had always been in place. For example, the new revenue recognition standard allowed companies to use a “modified retrospective” approach, where they didn’t need to revise previously reported financial statements but adjusted opening balances of retained earnings and other relevant accounts for the cumulative impact of the new standard.

In some instances, changes in accounting policies, such as switching from one acceptable inventory costing method to another, are required. Unless impractical, these changes should generally be applied retrospectively. The financial statement notes should explain and justify the change.

Apart from policy changes, companies sometimes adjust accounting estimates, like the useful life of a depreciable asset. These changes are handled prospectively, affecting only the financial statements for the period of the change and future periods. Prior statements are not adjusted, and the change is not highlighted on the income statement’s face. Significant changes in estimates should be disclosed in the notes.

Additionally, companies may need to correct errors from previous periods. This is done by restating the financial statements for the prior periods presented in the current financial statements.

Changes in Scope and Exchange Rates

In a case where an issuer acquires a controlling interest in another company, the financial statements are consolidated from the acquisition’s closing date. The relative size of the acquired company can significantly affect the comparability of the acquirer’s financial results and position in previous periods.

Moreover, fluctuations in exchange rates can influence the income statements of multinational corporations, impacting reported revenues. Although accounting standards do not require the disclosure of the effects of changes in scope or exchange rates on financial statements, many issuers provide summary information, such as revenue and earnings per share growth rates excluding these changes, in management reporting or other documents.

Question

Which of the following statements is most likely accurate?

1. Changes in accounting policies should always be applied prospectively.
2. Unusual or infrequent items should be presented separately in a company’s continuing operations.
3. An analyst should include discontinued operations in assessing a company’s future financial performance.

Solution

The correct answer is B.

Unusual, infrequent, or items that fall in both categories are presented separately as part of a company’s continuing operations.

A is incorrect. Changes in accounting policies do not always have to be applied prospectively. They can also be applied retrospectively. In fact, unless it is impractical to do so, it is preferred that changes in accounting policies are reported through retrospective application.

C is incorrect. Analysts should exclude discontinued operations from assessing a company’s future financial performance.