THE NATURE OF NONRECURRING ITEMS
Defining nonrecurring items is difficult. Writers often begin with phrases like “unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in their popular intermediate accounting text use the term irregular to describe what most statement users would consider nonrecurring items. For our purposes, irregular or nonrecurring revenues, gains, expenses, and losses are not consistent contributors to results, in terms of either their presence or their amount. This is the manner in which we use the term nonrecurring items throughout this chapter.
From a security valuation perspective, nonrecurring items have a smaller impact on share price than recurring elements of earnings. Some items, such as restructuring charges, litigation settlements, flood losses, product recall costs, embezzlement losses, and insurance settlements, can easily be identified as nonrecurring. Other items may appear consistently in the income statement but vary widely in sign (revenue versus expense, gain versus loss) and amount. For example, the following gains on the disposition of flight equipment were reported over a number of years by Delta Air Lines:
1992 $35 million
1993 65 million
1994 2 million
1995 0 million
1996 2 million
The gains averaged about $25 million over the 10 years ending in 1996 and ranged from a loss of $1 million (1988) to a gain of $65 million (1993). The more recent five years typify the variability in the amounts for the entire 10- year period. These gains did recur, but they are certainly irregular in amount.
There are at least three alternative ways to handle this line item in revising results to identify sustainable or recurring earnings. First, one could simply eliminate the line item based on its highly inconsistent contribution to results. Second, one could include the line item at its average value ($25 million for the period 1987 to 1996) for some period of time. Third, one could attempt to acquire information on planned aircraft dispositions that would make possible a better prediction of the contribution of gains on aircraft dispositions to future results. While the last approach may appear to be the most appealing, it may prove to be difficult to implement because of lack of information, and it may also be less attractive when viewed from a cost-benefit perspective. In general, we would normally recommend either removing the gains or simply employing a fairly recent average value for the gains in making earnings projections.
After 1996, Delta Air Lines disclosed little in the way of nonrecurring gains on the sale of flight equipment. Its 2000 annual report, which covered the years from 1998 to 2000, did not disclose any gains or losses on the disposition of flight equipment. With hindsight, the first option, which would remove all of the gains and losses on flight equipment, may have been the most appropriate alternative.
The Goodyear Tire and Rubber Company provides a timeless example of the impact of nonrecurring items on the evaluation of earnings performance. Exhibit 2.2 shows pretax results for Goodyear, with and without losses on foreign exchange.
As with Delta Air Lines, it may seem questionable to characterize as nonrecurring exchange losses that appear repeatedly. However, in line with the key characteristics of nonrecurring items given earlier, Goodyear’s foreign exchange losses are both irregular in amount and unlikely to be consistent contributors to results in future years. Across the period 1993 to 1995 the reduction in foreign exchange losses contributed to Goodyear’s pretax results by $35.5 million in 1994 and $60.2 million in 1995. That is, the entire $60.1 million increase in earnings for 1995 could be attributed to the $60.2 million decline in foreign exchange losses. The only way that the foreign exchange line could contribute a further $60.2 million to pretax earnings in 1996 would be for Goodyear to produce a foreign exchange gain of $42.8 million ($60.2 − $17.4).
Other examples of irregular items of revenue, gain, expense, and loss abound. For example, there were temporary revenue increases and decreases associated with the Gulf War. (“Sales to the United States government increased substantially during the Persian Gulf War. However, sales returned to more normal levels in the second half of the year.”) Temporary revenue increases have been associated with expanded television sales due to World Cup
soccer. Temporary increases or decreases in earnings have resulted from adjustments to loan loss provisions resulting from economic downturns and subsequent recoveries in the financial services industry. Most recently, there have been widely publicized problems with tires produced for sports utility vehicles that will surely create substantial nonrecurring increases in legal and warranty expenses.
Identifying nonrecurring or irregular items is not a mechanical process; it calls for the exercise of judgment and involves both line items and as the period-to-period behavior of individual income statement items.