When assessing a company’s possible future performance, it is useful to separate recurring items from non-recurring items. Recurring items are those items of income and expense that are likely to continue in the future, while non-recurring items are those which are less likely to continue.
The effects of changes in accounting policies should also be considered when assessing a company’s possible future performance, as these can materially change how information is presented in the financial statements.
Examples of non-recurring items are discontinued operations and unusual or infrequent items.
IFRS and US GAAP both require that a company reports separately in its income statement the effect of discontinued operations i.e. operations which the company has disposed of, or intends to dispose of, and in which it will no longer be involved. Since the company will no longer obtain earnings or cash flow from discontinued operations, they can be eliminated in any assessment of the company’s potential future financial performance.
Unusual or infrequent items
Since December 15, 2015, US GAAP requires material items that are unusual, infrequent or both to be presented separately as part of a company’s continuing operations. One such example would be the costs associated with a company’s restructuring exercise.
Changes in accounting policies
Changes in accounting policies may be applied to a company’s financial statements either prospectively or retrospectively. Retrospective application means that the company’s financial statements are presented as if the newly adopted accounting principle had been used for all fiscal years that are reflected in the financial report. Prospective application means that the changes in accounting policies are applied in the future. Notwithstanding, unless it is impractical to do so, changes in accounting policies should be reported through retrospective application, and the notes to the financial statements should describe the change and provide justification for the change.
Companies also sometimes make changes in accounting estimates. These are handled prospectively, with the change affecting the financial statements for the period of change and future periods.
An adjustment may also be made to correct an error from a prior period by restating the financial statements for the prior periods that are presented in the current financial statements.
Which of the following statements is accurate?
A. Unusual or infrequent items should be presented separately as part of a company’s continuing operations.
B. Changes in accounting policies should always be applied prospectively.
C. An analyst should include discontinued operations in an assessment of a company’s future financial performance.
The correct answer is A.
Unusual items, infrequent items or items which are considered both are presented separately as part of a company’s continuing operations.
Option B is incorrect because 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.
Option C is incorrect because analysts should exclude and not include discontinued operations in an assessment of a company’s future financial performance.
Reading 21 LOS 21e:
Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies)