Extraordinary Item - How They Should be Treated

The much awaited reporting season is here again and a careful review of any vested company should be done for an understanding of the direction of which the company is heading towards. Such a review can be timely to provide sufficient reasons in divesting or investing in a company, especially so when the reason for investing in it has changed for better or for worse. However, we may face with extraordinary items which can have a massive impact on the company's bottom line which will seriously complicate the matter.

Extraordinary items are usually stated in the financial statement in a separate line from the revenue. They are meant to be a one-off and infrequent event that should not occur often in the normal course of business. In fact, I will seriously consider part of the revenue as extraordinary profit so long as they are not generated from the core business or as mentioned "should not occur often in the the normal course of business". This is so that one can be conservative in the calculation and since one should not expect it to reoccur again in the next year or so.

Therefore, the frequency and likelihood of occurrence are to be the first factor in assessing these extraordinary item. If they are indeed that unlikely to occur, then they can be easily dismissed. In such a case, I will want a huge extraordinary loss so that I can buy at a much cheaper price provided that the company has sufficient financial strength to survive through it. Such example might be "Act of God", selling off of operation, lawsuit settlement or compensation.

However, in certain cases, such one-off event can be recurring of which then requires some careful examining. For e.g. the company might have a factory located in a flood-prone area in Thailand. After the flood, if the management treats this as a one-off event and not implement any measures like relocation or implementation of anti-flood measures, you can expect to have recurring extraordinary item year after year. Just look at how many times Wendy's at Liat Tower has suffered a loss for it, from damage to equipment to loss of income from closure of shop.

While extraordinary items are infrequent and should be discounted from the bottom line, they are not meant to be simply discarded. At the end of the day, they will still have an impact on the company's balance sheet and financial strength. One should be happy with the selling off of a high capex, unprofitable, cash-bleeding non-core operation. A lump-sum investment gain or settlement losses can double or halve the cash holding of a company and can even affect the dividend paid. In certain case, the company might return cash to the investor like in the case of San Teh. While the Japan's earthquake and nuclear incident are an Act of God, the company will face huge losses of physical asset and will have to fork out a rebuilding cost unless a catastrophic insurance is purchased.

In another very special case, a company in a recessionary financial year might choose to take extraordinary provision or losses since losses might be expected anyway. What happens might then be that losses that should have occurred in the next FY or so has been accounted in the current one. For the next FY, the company will have a huge turnaround with massive profit gain where in fact the gain should have been minimized. It will then be very hard to assess the company's profit other than perhaps to combine the results for the past years and average it out.

To conclude, extraordinary items should be treated with extraordinary care and caution. A comprehensive analysis is needed for an understanding of its impact to the 3 different financial statements. The worse of all will be if the management fails to recognize a one-off event or if a "Big Bath" is being taken.