Reasons to Report Extraordinary Gains and Losses on Your Income Statement - dummies

Reasons to Report Extraordinary Gains and Losses on Your Income Statement

Many businesses report unusual, extraordinary gains and losses on their income statements. If your business has extraordinary gains and losses to report, your business’s income statement is divided into two sections:

  • The ordinary, continuing sales, income, and expense operations of the business

  • Any unusual, extraordinary, and nonrecurring gains and losses that the business recorded

The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of the blue, doesn’t happen regularly or often, and can dramatically affect its bottom-line profit. Here are some examples of discontinuities:

  • Downsizing and restructuring the business: Layoffs require severance pay or trigger early retirement costs; major segments of the business may be disposed of, causing large losses.

  • Abandoning product lines: When you decide to discontinue selling a line of products, you lose at least some of the money that you paid for obtaining or manufacturing the products.

  • Settling lawsuits and other legal actions: Damages and fines that you pay — as well as awards that you receive in a favorable ruling — are obviously nonrecurring extraordinary losses or gains (unless you’re in the habit of being taken to court every year).

  • Writing down (also called writing off) damaged and impaired assets: If products become damaged or unsellable for some other reason, or fixed assets need to be replaced unexpectedly, you need to remove these items from the assets accounts.

  • Changing accounting methods: A business may decide to use a different method for recording revenue and expenses than it did in the past, and the new method may require you to record a one-time cumulative effect caused by the switch in accounting method.

  • Correcting errors from previous financial reports: If you discover that a past financial report had an accounting error, you make a catch-up correction entry, which means that you record a loss or gain that had nothing to do with your performance this year.

Every company that stays in business for more than a couple years experiences a discontinuity of one sort or another. But beware of a business that takes advantage of discontinuities in the following ways:

  • Discontinuities become continuities: This business makes an extraordinary loss or gain a regular feature on its income statement. Every year or so, the business loses a major lawsuit, abandons product lines, or restructures itself. It reports “nonrecurring” gains or losses from the same source on a recurring basis.

  • A discontinuity is used as an opportunity to record all sorts of write-downs and losses: When recording an unusual loss, the business records other losses at the same time, and everything but the kitchen sink gets written off. This so-called big-bath strategy says that you may as well take a big bath now in order to avoid taking little showers in the future.

A business might just have bad (or good) luck regarding extraordinary events that its managers could not have predicted. If a business is facing a major, unavoidable expense this year, cleaning out all its expenses in the same year so it can start off fresh next year can be a clever, legitimate accounting tactic. But where do you draw the line between these accounting manipulations and fraud? The best advice is simply to stay alert to these potential problems.