In Practice: Dealing with Extraordinary and Other Nonrecurring Expenses

Much of financial analysis is built around the expected future earnings of a firm, and many of these forecasts start with the current earnings. It is therefore important that we know how much of these earnings are from the ongoing operations of the firm, and how much can be attributed to unusual or extraordinary events, that are unlikely to recur on a regular basis. Nonrecurring items include the following:
1. Unusual or Infrequent items, such as gains or losses from the divestiture of an asset or division, and write-offs or restructuring costs. Companies often include such items as part of operating expenses. As an example, Boeing in 1997 took a write-off of $1,400 million to adjust the value of assets it acquired in its acquisition of McDonnell Douglas, and showed this as part of operating expenses.
2. Extraordinary items, which are defined as events which are unusual in nature, infrequent in occurrence and material in impact. Examples include the gain associated with refinancing high coupon debt with lower coupon debt, which creates an accounting gain, and gains or losses from marketable securities that are held by the firm.
3. Losses associated with discontinued operations, which measures both the loss from the phase out period and any estimated loss on sale of the operations. To qualify, however, the operations have to be separable from the firm.
4. Gains or losses associated with accounting changes, which measure earnings changes created by accounting changes made voluntarily by the firm (such as a change in inventory valuation) and accounting changes mandated by new accounting standards.
It is useful that firms categorize expenses into operating and nonrecurring expenses, since it is the earnings prior to extraordinary items that should be used in forecasting. In practical terms, however, cleansing earnings of extraordinary items is made more difficult by the following factors:

1. Firms are not consistent when it comes to separating ordinary from extraordinary gains and losses. Firms sometimes show write-offs and restructuring charges as part of the operating expenses, though they add footnotes to the effect that these are not normal expenses. Thus, it is up to the analyst to peruse the footnotes and make the necessary corrections to the earnings.
2. In recent years, we have been witnesses to the strange phenomenon of recurring nonrecurring expenses, i.e., nonrecurring expenses that show up year after year in a firm’s financial statement. This would suggest that some firms are taking advantage of the looseness in the distinction to classify operating expenses as nonrecurring expenses.
3. When it comes to restructuring charges and write-offs, firms seem to vary in how they estimate these charges. More conservative firms seem to assess larger charges than less conservative firms, and this affects reported earnings.
4. A related and even more dangerous trend seems to be the use of restructuring charges as a device to improve future earnings and profitability. By taking large restructuring charges, firms reduce depreciation in future periods and thus increase earnings. This is accentuated when profitability is measured on a return basis, since the book value of capital and equity is also reduced by large restructuring charges.

These trends suggest that analysts should look at nonrecurring charges with skepticism, and the adjustments should reflect what they see. If the nonrecurring charges are really operating expenses, they should be treated as such and earnings estimated after these charges. If the nonrecurring charges are truly nonrecurring, earnings should be estimated prior to these charges. When it comes to computing return on equity and capital, however, more reliable estimate may be obtained if the book value of equity and capital are estimated prior to extraordinary charges, not just in the current period but cumulatively over time.