Discussion:

Does presentation matter? Considering the article below and chapter 4 of K&W, 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.

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 inAccounting 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 AICPA's 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 AICPA's issuance of pronouncements. Two APB pronouncements dealt with the determination of extraordinary items: Opinions 9 and 30, both titledReporting the Results of Operations.

APB Opinion 9 (1966) stated that extraordinary items were events that differed significantly enough from an entity's 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. FASB's 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" ("FASB's Emerging Issues Task Force Decides Against Extraordinary Treatment for Terrorist Attack Costs," FASB news release, October 1, 2001;www.fasb.org/eitf/eitf91101.shtml).

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;www.fasb.org/eitf/eitf91101.shtml). 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 Can't Account for Attacks as Extraordinary Items," CNNMoney.com, October 1, 2001;money.cnn.com/2001/10/01/news/fasb).

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 management's 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 SEC's 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, 'We've had acatastrophicfailure'" ("Katrina Report Blames Levees," CBS/AP, CBS News, June 1, 2006;www.cbsnews.com/stories/2006/06/01; 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 IASB's decision on extraordinary items and FASB's 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 1shows 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 FASB's 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 company's 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.