A special item is an unusual transaction or event that management discloses separately that is not expected to recur on a regular basis. Special items occur during normal business cycles and are typically reported separately based on management’s judgment. They are used to differentiate normal business transactions from one-time transactions that do not occur regularly.
Special items are reported separately from ordinary income since they are non-recurring and irregular to allow for the proper valuation of a company’s financial performance. Examples of special items are restructuring charges, special executive compensation, asset write-offs, litigation settlements, income from discontinuation of debt, etc.
Accounting standards identify a special item as a one-time financial transaction that appears separately on a company’s financial statements.
For an event or a transaction to meet the definition of a special item, it must be unusual in nature and occur infrequently.
Because it is up to management’s discretion whether an item is separately disclosed apart from its usual business activities, a company’s financial health may be manipulated to look better or worse than it really is.
Understanding Special Items
Special items are essentially events or transactions identified by management, infrequent in occurrence, and unusual in nature. Businesses, on rare occasions, experience one-time events whose effect on income is unexpected.
Even so, companies that frequently report special items are often suspected of doing so opportunistically because of their subjective nature. Frequent reporting of special items may suggest business instability or manipulation by management and will affect the valuation of a company.
Accounting reporting requirements classify a special item using two criteria, namely:
1. Unusual in nature
Companies use their operating policies and type and scope in determining whether an activity or event is a special item. Classifying a transaction or event as a special item varies across companies since differences in respective environments may render an event a special item for one company but not another.
2. Infrequency in occurrence
A business transaction or event is considered infrequent if it is not expected to recur in the foreseeable future. The evidence of a past occurrence is used to assess the likelihood of a recurrence and takes into account the environment in which a company operates. The reason behind such an approach is that the likelihood of a specific event reoccurring may vary, depending on a company.
Presentation and Taxation of Special Items
Financial reporting standards require that special items be shown separately either in the notes to the financial statements or on the income statement. They are separated out from normal business activity results to allow for the comparison of results across accounting periods.
Circumstances arise when necessary to show a special item’s financial statement separately to offer a fair presentation. Special items tax impact are also separately disclosed to allow for better comparison.
Manipulation of Special Items in Financial Statements
Some transactions or business events occur only once, or at least infrequently. Nevertheless, most businesses incorrectly misclassify unique charges during normal business cycles as one-time charges. This deliberate manipulation aims to improve a company’s financial health to deceive investors. Unfortunately, the practice is an ongoing and common problem.
Some companies even go a notch higher and use restructuring charges to improve future cash flow and profitability. Usually, large restructuring charges are used to conceal operation weaknesses and reduce the projected future depreciation to increase earnings. It is made more prominent when returns are used to measure profitability since large restructuring charges reduce the capital and equity’s book values.
For this reason, special items are noted with skepticism by financial statement users, especially if the adjustments are made frequently, or when management may be susceptible to manipulating results. One-time charges that qualify to be operating expenses should be treated as normal operating earnings. However, for special items that meet the definition of a one-time charge, companies should ensure they are unusual and infrequent to maintain investor confidence.
Accounting for Costs Associated with Special Items
The manipulation of special items on financial statements does not come as a surprise. In response to concerns over the increased labeling of costs associated with unusual events as liabilities, the Financial Accounting Standard Board (FASB) issued FAS 146, which requires companies to recognize costs associated with exit or disposal activities as liabilities.
FAS 146 improves financial reporting by limiting companies on the type of charges to be included in a restructuring charge to curb expense-shifting practices. Some of the implied costs include expenses incurred to relocate employees or consolidate facilities, terminate a contract that is not a capital lease, and terminate current benefits to employees subject to the terms of a beneficial arrangement, among others.
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