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Time to Eliminate the Classification




Time to Eliminate the Classification;Extraordinary Items: Time to Eliminate the Classification;By Marcos Massoud, Cecily Raiborn, and Joseph Humphrey;FEBRUARY 2007 - Under current GAAP, the criteria mandated in Accounting Principles Board;(APB) Opinion 30 have so restricted the ability of items to be classified as extraordinary that in;2003 only 2% of the entities included in Accounting Trends and Techniques, 60th;Edition (AICPA, 2006) reported extraordinary items. Under International Accounting Standard;(IAS) 1, entities are prohibited from classifying any item as extraordinary. Given that two recent;catastrophic eventsSeptember 11, 2001, and Hurricane Katrinawere deemed to be;nonextraordinary, and the desire for the convergence of U.S. and international GAAP, the;authors believe that it is time for the extraordinary-item classification to be eliminated.;Background on Extraordinary Items;Discussion of extraordinary items (EI) is not new. The first document mentioning the term;Uniform Accounting, was issued in 1917 by the Federal Reserve Bank, but prepared by an;AICPA committee. This pamphlet was reissued the following year as Approved Methods for the;Preparation of Balance Sheet Accounts. These statements recommended an income statement;that showed extraordinary gains and losses on its face after determination of net income for the;period. In the 1920s, however, extraordinary items were typically accounted for directly in the;retained earnings (or surplus) account. Often there was little, if any, disclosure of what;constituted an extraordinary item, and accountants tended to view these in a rather liberal;manner (Weldon Powell, Extraordinary Items, Journal of Accountancy, January 1966). The;income statement simply indicated to users that income or loss for the period had been;determined excluding extraordinary items.;When the SEC was formed in 1934, it agreed with the American Accounting Association and;advocated the use of an all-inclusive income statement model rather than a current operating;performance model. As such, extraordinary items would be shown on the income statement but;separated from regular, recurring revenues, expenses, gains, and losses. In its 1936 Examination;of Financial Statements, the AICPA was slightly at odds with the SEC and AAA by allowing but;not requiring an income statement presentation containing extraordinary items.;The AICPA continued the discussion of the treatment of EIs in Accounting Research Bulletin;(ARB) 8,Combined Statement of Income and Earned Surplus (1941), and ARB 32, Income and;Earned Surplus (1947). These ARBs took a modified all-inclusive approach, promulgating the;income statement as the appropriate document in which to present the majority of financial;transactions for the current period, with the exception of transactions with investors and material;items that were clearly not identifiable with current business operating performance. When the;AICPA published ARB 43, Restatement and Revision of Accounting Research Bulletins Nos. 1;42, in 1953, the following items, when material, were specified as allowed to be excluded from;net income if the inclusion would cause users to draw misleading conclusions from an analysis;of net income;Nonrecurring amounts specifically related to prior years operations, such as;eliminating previously established retained earnings reserves or adjusting past income;taxes;Amounts resulting from unusual sales of assets not of the type in which the company;commonly deals;Losses from disasters not commonly insured against (e.g., wars, riots, and;earthquakes), unless such losses are a recurrent business hazard;Losses from completely writing off intangibles, such as goodwill or trademarks, and;Amounts from writing off unamortized bond discounts, bond premiums, or bond issue;expenses when the related debt is retired or refunded before maturity.;Even with the individual items detailed, ARB 43 did not identify criteria to ascertain when;inclusion of these items would so significantly affect net income as to make inferences;misleading, nor did it identify methods by which such items, if not contained on the income;statement, should be presented. Thus, reporting practices were disparate. The AICPAs attempt to;clarify presentational issues in ARB 35 (1948) had recommended that such extraordinary items;be shown as part of the statement of retained earnings.;APB Opinions;The APB was established in 1959 and disbanded in 1973. It was formed to research topical areas;prior to the AICPAs issuance of pronouncements. Two APB pronouncements dealt with the;determination of extraordinary items: Opinions 9 and 30, both titled Reporting the Results of;Operations.;APB Opinion 9 (1966) stated that extraordinary items were events that differed significantly;enough from an entitys customary business activities as to make those events unlikely to often;reoccur, however, Opinion 9 gave no explicit criteria for categorizing an item as extraordinary or;ordinary. Opinion 9 did provide examples of gains and losses that would (assuming materiality);be considered extraordinary: the sale or abandonment of a plant or a significant segment of a;business, the sale of an investment not acquired for resale, the write-off of goodwill because of;unusual circumstances within the period, the condemnation or expropriation of properties, and;the major devaluation of a foreign currency. Additionally, the following items were specifically;designated as not being extraordinary items because they were considered to be of a typical;business character: write-downs of receivables, inventory, and research/development costs;adjustments of accrued contract prices, and gains/loses from foreign exchange fluctuations. APB;Opinion 26, Early Extinguishment of Debt (1972), stated that the criteria in APB 9 should be;used to determine whether any difference between the net carrying value of the extinguished debt;and the reacquisition price should be classified as extraordinary.;In Opinion 30 (1973), the APB noted that recent financial reporting practices indicated that;companies were having difficulty interpreting Opinion 9 criteria for extraordinary items;resulting in a variety of ideas about what was and was not extraordinary. Thus, Opinion 30;provided more-specific criteria for determining extraordinary items. The guidance stated that, for;an event or transaction to be classified as extraordinary, it had to be both unusual in nature;(abnormal) and infrequent in occurrence (not reasonably expected to recur in the foreseeable;future), both criteria needed to be judged based on the environment in which the organization;operated. At that time, and given the new criteria, the APB reversed Opinion 9 by stating that;gains and losses from the disposal of a segment, although to be shown in a separate classification;on the income statement, were not extraordinary items.;FASB Standards;Although FASB has not released an individual standard on extraordinary items since its inception;in 1973, it has generated several standards that address the issue. Statement of Financial;Accounting Standard (SFAS) 4,Reporting Gains and Losses from Extinguishment of Debt (1975);was issued in response to public demand for better guidelines on reporting debt extinguishment.;SFAS 4 stated that any gain or loss from the extinguishment of debt, regardless of whether that;debt was extinguished before or on its maturity date, would be included on the income statement;as an extraordinary item. The only exclusion to such a presentation was when cash purchases;were made for debt to meet sinking-fund requirements. This exception was eliminated in 1982;when FASB issued SFAS 64, Extinguishments of Debt Made to Satisfy Sinking-Fund;Requirements, thereby amending its previous decision and effectively making most forms of debt;extinguishment extraordinary items. Only one exception was continued in SFAS 64, for gains;and losses from extinguishments of debt that were made to satisfy sinking-fund requirements;required within one year of the extinguishment date.;FASB, however, did a complete reversal of all its previous conclusions relative to the;extinguishment of debt in 2002 when it issued SFAS 145, Rescission of FASB Statements No. 4;44, and 64, which stated that extinguishments of debt were typically normal and recurring events;for business entities, and, as such, the gains and losses from such extinguishments should not be;considered extraordinary unless they meet the unusual in nature and infrequent in occurrence;criteria as provided in APB Opinion 30.;The impact of SFAS 145 was dramatic. The elimination of gains and losses from debt;extinguishments as extraordinary items significantly changed income statement presentations.;For example, in 2002, there were 40 debt extinguishment gains and losses included in;extraordinary items, in 2003, there were only four. Additionally, in 2003, only 2% of companies;presented extraordinary items.;In SFAS 96, Accounting for Income Taxes (1987), a revision of APB Opinion 11 of the same;name, FASB decided that any operating-loss carryforward benefit resulting from an;extraordinary gain should be treated as an extraordinary item when it is recognized. SFAS;109, Accounting for Income Taxes (1992), reversed that classification because tax benefits are;not unusual and infrequent, as required under APB Opinion 30.;SFAS 141, Business Combinations (2001), added another item to the list of extraordinary items;negative goodwill. FASB stated that when the fair values of the acquired assets of a company;were greater than the acquisition price of that company, the excess would first be used to make;pro rata reductions in the fair values of the acquired assets (with certain exceptions, as stated in;paragraph 44), should there be any excess remaining, it would be written off as an extraordinary;gain.;It appears that, after some debate and ambiguity, FASB has decided that the criteria originally;stated in APB Opinion 30 should, in fact, be used to assess whether an item should be classified;as extraordinary.;Recent Non-Extraordinary Events;The 21st century has seen two very different events in the United States: the terrorist attacks on;September 11, 2001, and Hurricane Katrina on August 29, 2005. Both costly events were;consistently described in the media as extraordinary, but neither qualified for such a;classification for financial reporting purposes. FASBs Emerging Issues Task Forces (EITF);stated that while the events of September 11 were certainly extraordinary, it determined that;attaching such a label to organizational losses would not effectively communicate the financial;effects of those events and should not be used in this case (FASBs Emerging Issues Task;Force Decides Against Extraordinary Treatment for Terrorist Attack Costs, FASB news release;October 1, 2001,;Losses from the September 11 terrorist attacks. The September 11, 2001, terrorist attacks;brought both personal and economic tragedy to the United States. The insured losses amounted;to approximately $50 billion, making them the largest insured single-event loss in history, far;exceeding the approximately $20 billion in losses from Hurricane Andrew in 1992 (The State of;the Insurance Market, Equity Risk Partners white paper, October 1;2001, Business impacts were so widespread that the Small;Business Administration changed its Economic Injury Disaster Loans program to give access to;such loans to businesses in the entire country rather than only to the Presidentially designated;disaster areas.;Given the monumental financial implications and the onset of the end of the third quarter of;many business years, the EITF met on September 20, 2001, to discuss how September 11 losses;should be handled on financial statements. The following tentative conclusions were generated at;that meeting;The direct losses and costs, including cleanup, related to the attacks should be;classified on the income statement as extraordinary items and include footnote disclosure.;American Airlines and United Airlines should classify aircraft loss, insurance;settlements to victims families, exit costs related to layoffs, and asset impairments;related to the attacks as extraordinary items and include footnote disclosure.;The losses of the insurance industry should not be classified as extraordinary.;The final conclusions of the EITF were, however, very different from those tentative ones. The;EITF decided that attempting to separate direct and indirect costs was too complicated and that;there was no clear and consistent solution (Chris Isidore, Accounting Board: Firms Cant;Account for Attacks as Extraordinary Items,, October 1;2001,;The EITF also thought that it was too difficult to distinguish the financial impacts of the attacks;from the effects of a weak economy that predated those attacks (Jill Giles and Richard C. Jones;Accounting and Auditing Issues Surrounding the September 11 Disasters, The CPA Journal;November 2001).;On September 28, 2001, the EITF concluded that no company should treat any of the losses and;costs arising out of the events of September 11, 2001, as extraordinary.;The decision to disallow extraordinary-item treatment for the impacts of September 11, 2001;was certainly not designed to discount the damage of those attacks on the economy. Members of;the EITF believed that the related cost of the events were pervasive in the affected organizations.;Trying to draw a line between costs that could be labeled extraordinary, and shown below;income from discontinued operations, and those that could not be was not only impractical, but;also not helpful to financial statement users most concerned with information that would help;them forecast the future earnings and cash-flow impacts of these events. Attempts to disassociate;costs into ordinary and extraordinary classifications would hamper rather than improve effective;financial-information communication. The EITF indicated that the impacts of the terrorist attacks;should be described in financial statement footnotes and in managements discussion and;analysis (MD&A) sections of SEC 10-K and 10-Q filings.;Losses from Hurricane Katrina. The storm that hit the Gulf Coast on August 29, 2005, left;hundreds of thousands of people homeless and almost 2,000 people dead, it also caused more;than $80 billion of damagethe most costly natural disaster in U.S. history. The loss impact;from Hurricane Katrina went far beyond those people and businesses in the area directly hit by;the storm. There was also severe damage to the energy and transportation sectors of the;economy, as well as detrimental effects to any business that relied on selling to, buying from, or;distributing through the affected Gulf Coast area. Only some of the damages were covered by;insurance.;Unlike the events of September 11, there was no wavering about how the financial implications;of Hurricane Katrina were to be recorded. While the magnitude of the economic devastation was;enormous, hurricanes are natural disasters that affect businesses periodically, hurricanes do not;meet the unusual in nature and infrequent in occurrence criteria, especially in the Gulf Coast;area, where many businesses that suffered damages operated. The size of the losses sustained did;not allow the criteria to be ignored, the issue of magnitude of losses from a natural disaster had;been previously addressed by the SECs Division of Corporation Finance in its March 2000;document Accounting Disclosure Rules and Practices, which states that using monetary;damages to ascertain whether a disaster is extraordinary is generally inappropriate. In some;instances, however, an extraordinary classification has been available for natural disasters, in;1980, the losses sustained by businesses impacted by the eruption of Mount St. Helens were;considered extraordinary because that mountain had not erupted in over 130 years.;With regard to the losses associated with Hurricane Katrina, however, one other issue should be;noted. Although the storm itself caused significant damage, much of the financial loss in New;Orleans occurred because of the failure of the levees to withstand the storm surge. Responsibility;for the levee failure has been accepted by the U.S. Army Corps of Engineers. Corps chief Lt.;General Carl Strock stated, This is the first time that the Corps has had to stand up and say;Weve had a catastrophic failure (Katrina Report Blames Levees, CBS/AP, CBS News;June 1, 2006,, emphasis added).;Given the specific words used in that statement, there might be a question of whether the losses;caused by the failure of the levees would, in fact, be unusual in nature and infrequent in;occurrence in the environment where business operates. But, similar to the difficulty of;separating one type of loss from another in the September 11 terrorist attacks, there would also;be tremendous difficulty differentiating between losses from Hurricane Katrina and losses from;the failure of the levees. The easier approach would be to consider all of the losses as ordinary.;Given that the financial implications of Hurricane Katrina, like those of the September 11;terrorist attacks, were pervasive and significant to users, extensively affected companies issued;SEC Form 8-Ks to announce a major event of importance to stockholders as well as to provide;information in the footnote and MD&A sections of their quarterly and annual SEC filings. Many;companies treated their Katrina losses as nonrecurring or one-time events, others, choosing not;to reopen facilities, might be able to report the losses in the discontinued-operations section of;their income statement.;International Considerations;In October 2002, FASB and the International Accounting Standards Board (IASB) announced in;a memorandum of understanding (the Norwalk Agreement) that they would move to reduce or;eliminate areas of difference between the two sets of standards through a process of convergence.;The European Union had, in 2001, stated that it would adopt IASs for all listed companies, full;compliance was set to occur by January 2005. This date, however, has not been met.;One area of disagreement between FASB and the IASB is related to extraordinary items. While;in the United States definitions and examples of extraordinary items have been specified and;specific events have been excluded from that classification, the IASB decided on a position that;was more attuned with Australian, Canadian, New Zealand, and United Kingdom accounting;practices, which have such narrow definitions of extraordinary items as to make them almost;nonexistent. Ultimately, the IASB took the final step. IAS 1,Presentation of Financial;Statements (2003), states that neither the income statement nor any notes may contain any items;called extraordinary. The justification for the decision was the difficulty of objectively;separating the financial effects of one event from those of another (see Jacqueline Burke, An;Extraordinary Decision Leads to Extraordinary Changes, The CPA Journal, June 2004). This;rationale reflects thinking similar to that made by FASB in excluding from the extraordinary;category the losses from the September 11 terrorist attacks and Hurricane Katrina.;While the underlying bases for the IASBs decision on extraordinary items and FASBs decisions;on two specific events are the same, the end results indicate the disparity between the two boards;in terms of principles versus rules. By simply eliminating the extraordinary category, the IASB;requires financial statement preparers and auditors to use their judgment in analyzing the;financial implications of a particular event for a level of materiality and degree of importance in;the prediction of future cash flows to determine whether the event necessitates separate;disclosure on the face of the income statement, in the footnotes to the financial statements, or;both. Alternatively, FASB clings to its rules-based mentality of designating certain items as;extraordinary. When difficult judgments or allocations would need to be made, as in September;11 and Hurricane Katrina, FASB opts to state that regardless of how extraordinary the event was;from the standpoint of the media, the public, the affected organization, or the economy, the event;did not meet the established rules.;Reasons to Eliminate Extraordinary Items;A variety of reasons indicate the time has come to eliminate the category of extraordinary items;from the income statement.;First, there is the obvious uncertainty of the American arbiters of financial reporting about what;is and what is not an extraordinary item. Exhibit 1 shows the changes that have occurred in U.S.;accounting definitions of and qualifying events for extraordinary items. This uncertainty is;especially obvious with regard to gains and losses from early extinguishment of debt, the;classification of which has changed numerous times over the years. Given the criteria provided;in APB Opinion 30, it is difficult to comprehend why FASB decided to make such gains and;losses extraordinary in SFAS 4 (even stating that such a classification was only meant to be;temporary), or why it took 27 years to almost fully rescind that classification after agreeing at the;time SFAS 4 was issued that applying APB Opinion 30 criteria to debt extinguishment;transactions would seldom, if ever, result in extraordinary gains or losses. Additional evidence;for FASBs uncertainty can be seen in its 180-degree reversal, in eight days, of the treatment of;the losses from the September 11 terrorist attacks.;Second, if megacatastrophes whose financial impacts cannot be captured on a single line item in;a companys income statement, or that cause companies to exit an entire market, are not;extraordinary, maybe the classification should be eliminated. The concept of materiality is an;overarching criterion in the determination of an extraordinary item. AICPA Technical Practice;Aid 5400.05 (2005), however, specifically states that the magnitude of loss from a particular;natural disaster does not cause that disaster to be unusual in nature or infrequent in occurrence.;Although the magnitude of loss (or gain) does not singularly indicate an extraordinary event;magnitude is the premier component of quantitative materiality. If an event has created financial;implications that have never been seen before and that, due to changes that have or will be;implemented, it is presumed will not happen again, it seems feasible that such an event should be;viewed as unusual in nature and infrequent in occurrence. Not allowing the extraordinary;classification for such events calls into question the legitimacy of that classification.;Third, the extraordinary-items category is used so infrequently in practice that it should be;eliminated. Exhibit 2presents information relative to extraordinary items from 1995 to 2004. As;the exhibit indicates, the primary use of the EI classification has been for gains and losses from;early extinguishment of debt. Because SFAS 145 has fundamentally rescinded the opportunity;for companies to include such gains and losses in the extraordinary category, its usage should be;even more minimal in the future. Additionally, although the vagueness of the phrases unusual in;nature and infrequent in occurrence is compatible with the trend toward principles-based;standards rather than rules-based standards, the fact that those phrases have been unilaterally;defined by the APB and FASB to mean only very specific items (certain natural disasters;prohibitions under newly enacted laws, expropriation of assets by a foreign government);eliminates the ability of financial statement preparers and auditors to use judgment in;determining events that meet the stated criteria.;Fourth, elimination of the extraordinary-items classification would be another step in the process;of the convergence of FASB and IASB standards. Given the rarity with which the classification;is used, its elimination would not present accounting or reporting hardships for companies and;would make comparisons of international financial statements more straightforward.;Time for Change;Over the years, the benefit of reporting extraordinary items as a separate section of the income;statement has been unclear. Classifying the financial implications of an event as extraordinary;does not change the bottom-line effects of that event on an organization. Such a classification;does, however, change the manner in which a financial statement user perceives that event, the;tendency is to pay less attention to such items and to discount or even ignore the possibility of;such occurrences on future financial reports. Additionally, regardless of where the line items;appear on the income statement, management can spin the information as it sees fit as long as;there is compliance with GAAP (Rachel Beck, Hurricane Costs Directly Hit Earnings, AP;September 16, 2005).;To view any event in an uncertain world as unusual in nature and infrequent in occurrence is;to disregard the potential for anomalies. In looking at the changes that have taken place in the;world since extraordinary items were first mentioned for accounting purposes in 1917, the only;rational conclusion that can be drawn is that nothing is extraordinary anymore. The public would;be well served if FASB would choose to follow in the footsteps of its international colleagues;and eliminate the classification altogether.;Marcos Massoud, PhD, CPA, is the Robert A. Day Distinguished Professor of Accounting at the;Peter F. Drucker Graduate School of Management of Claremont McKenna College, Claremont;Calif. Cecily Raiborn, PhD, CPA, CMA, is the McCoy Endowed Chair in Accounting at Texas;State University, San Marcos, Texas. Joseph Humphrey, PhD, CPA, is a professor of accounting;at Texas State University, San Marcos, Texas.;Discussion: Does presentation matter? Considering the article above and knowledge about;income statement please discuss the following;1. Whether the current presentation of extraordinary items (i.e. as a separate line item on the;income statement, net of tax, and below income from continuing operations) benefits the users of;financial reports.;2. Whether separating income from operations and net income on the income statement (i.e. by;using a multi-step format vs a single step format) adds benefit to the users of financial reports.


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