A one-time charge, or non-recurring item, is a line item that is reported on the financial statements of a firm on an irregular basis. It is unrelated to a firm’s normal business operations and arises from unexpected events like lawsuits, layoffs, asset sales, etc.
It is important to recognize and highlight a one-time charge because it can distort the financial picture and significantly change the results of important analyses like financial statement forecasting and valuation.
It is common for management to use one-time charges to understate or overstate the financial performance to change investors’ perception of the company. In the following sections, we will see some examples of misuse and what can be done to deal with one-time charges.
One-time Charges – Misuse
1. Overstating earnings
Sometimes, a company will boost its earnings by including an unusual gain within a regular line item on the income statement. One way is to include investment income in the total revenues.
Airline companies are often involved in fuel hedging to control their costs. Sometimes, hedging activities generate large profits. A company may decide to include such profits in their revenue numbers even though fuel hedging is not its core business.
2. Gaming metrics
A company can misuse one-time charges to gain important performance metrics by manipulating one of its components.
The P/E ratio comprises two components: price P and earnings-per-share E. The company cannot control the price as it is determined by the market, but it can reduce its earnings per share to inflate the P/E ratio. It can do this by writing down assets or aggressively booking expenses to one period.
3. False negative perception
A company may not always overstate performance. It can create a false one-time charge by aggregating most of their expenses in one period, say a quarter. This creates a false perception of a better future for the company, as other quarters will look like improvements from the previous performance, which was intentionally understated. This is sometimes referred to as sandbagging.
4. Improper reporting
A company may correctly report a one-time charge on one statement but improperly report it on another.
A company reports a one-time gain separately on the income statement, which makes it transparent to any reader of the financial statements. However, it then includes the increased net income on the income statement and uses it without an adjustment on the cash flow statement. It can easily mislead investors who do not examine all statements closely. A better way to report the one-time charge is to report it separately on the cash flow as well.
Dealing with One-time Charges
The above examples are only a few ways in which a one-time charge may be misused by a company. There are a lot of possibilities, and it is hard to document every instance of such misreporting. However, one can take certain measures to minimize the distortion. Some of the measures are:
Remove the effect of one-time charges on financial statements before conducting any analyses like forecasting and valuation. It is important because it not only depicts the financial situation more accurately but also because one-time charges are difficult to forecast.
Use operating numbers instead of bottom-line numbers, as operating numbers do not include the effect of one-time charges. For example, in the case of the P/E ratio above, using operating income instead of net income for earnings-per-share will lead to a more accurate metric for value.
Examine all financial statements collectively instead of independently. It can help detect the kind of improper reporting discussed above.
Be on the lookout for companies that use one-time charges repeatedly. It is highly likely that those are not one-time charges but regular costs of doing business. Such a practice is indicative of poor management.
Use GAAP/IFRS-compliant metrics and compare non-GAAP/IFRS metrics with their compliant counterparts as much as possible. Accounting standards evolve over time and ensure accuracy and rigor.
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