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1.3. Extraordinary Items

From time to time, a business may experience a gain or loss that results from an event that is both unusual in nature and infrequent in occurrence. When these two conditions are both met, the item is deemed to be an extraordinary item, and it is to be reported in a separate category below income from continuing (and discontinued, if applicable) operations. Extraordinary items are to be shown net of their related tax effect, as follows:

UFO CORPORATION Income Statement For the Year Ending December 31, 20X2

Sales

$ 5,500,000

Cost of goods sold

3,300,000

Gross profit

$ 2,200,000

Operating expenses

Salaries

$ 635,000

Rent

135,000

Other operating expenses

300,000

1,070,000

Income from continuing operations before income taxes

$ 1,130,000

Income taxes

400,000

Income from continuing operations

$ 730,000

Extraordinary item

Uninsured loss from meteorite strike at corporate office

$ 600,000

Income tax benefit from loss

130,000

Extraordinary loss net of tax

470,000

Net income

$ 260 000

What does and does not meet the conditions of unusual in nature and infrequent in occurrence? In the example above, I presumed that a meteorite hitting a business and causing a major loss met both conditions. Although meteorites do occur, it is indeed rare for one to hit a specific business and cause a major loss. It would be very unlikely that this same business would ever sustain this type of loss again. On the other hand, flood losses for businesses located along a river, earthquakes for businesses in the Pacific Rim, wind damage in coastal areas, airline crashes, and the like can give rise to losses that are not unusual in nature and may be expected to reoccur from time to time; these types of items would be reported in continuing operations as a separate line item.

HIGH WATER CORPORATION Income Statement For the Year Ending December 31, 20X7

Sales

$ 5,500,000

Cost of goods sold

3,300,000

Gross profit

$ 2,200,000

Operating expenses

Salaries

$ 635,000

Rent

135,000

Other operating expenses

300,000

Flood loss at Delta River facility

600.000

1,670,000

Income from continuing operations before income taxes

$ 530,000

Income taxes

270,000

Net income

$ 260 000

Criteria driven rules (e.g., "unusual in nature" and "infrequent in occurrence") can give rise to subjective assessments - how would you classify the effects of a tornado in Kansas, a major terrorist attack in New York, a drug recall because of newly discovered health risks, an asset seizure by a foreign government, and so forth? You likely have an opinion on each of these, but there is

1.4. Changes in Accounting Methods

Now and again, a company may adopt a change in accounting principle. Such accounting changes relate to changes from one acceptable method to another acceptable method. For instance, a company may conclude that it wishes to adopt an alternative inventory procedure (e.g., FIFO to average cost). These changes should only occur for good cause (not just to improve income in some particular period!), and flip-flopping on a regular basis is not permitted. When such a change is made, the company must make a retrospective adjustment. This means that the financial statements of prior accounting periods should be reworked as if the new principle had always been used. Substantively, this is no different than the treatment afforded error corrections (restatements). However, the FASB chose to attach the different phrase (retrospective adjustment) when the process is implemented for a change in accounting principle; the idea was to use a different term to distinguish between changes resulting from errors (which carry a stigma) and other types of changes.

Disclosures that must accompany a change in accounting principle are extensive. For starters, notes must be included that indicate why the newly adopted method is preferable. In addition, a substantial presentation is required showing amounts that were previously presented versus the newly derived numbers, with a clear delineation of all substantial changes. And, the cumulative effect of the change that relates to all years prior to the earliest financial data presented in the retrospectively adjusted information must also be calculated and disclosed. This is no small task, and a comprehensive illustration is well beyond the scope of any introductory accounting text.

Do not confuse a change in accounting method with a change in accounting estimate. Changes in estimate are handled prospectively. This type of change was illustrated in the property, plant, and equipment chapter. If your recall is a bit fuzzy, you should probably spend a few minutes to review that material. Also, take note that sometimes a change in principle cannot be separated from a change in estimate (e.g., changes in the approach to depreciating an asset); such changes are to be treated like a change in estimate and do not entail retrospective adjustments.

Likewise, do not confuse a correction of an error with an accounting change. If a company changed from FISH (first-in, still-here) to FIFO, this would be an error correction and require a prior period adjustment - in case there is any doubt, FISH is not an acceptable inventory method. Remember, accounting changes relate to changes from one acceptable method to another acceptable method.

 
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