What is an Extraordinary Item?
How Does an Extraordinary Item Work?
Let's assume that Company XYZ, an American company, operates a chain of beach resorts in the Florida Keys, and the resorts are hit by a blizzard. Company XYZ would show the expenses related to the blizzard in a separate line item on the income statement (under the header "Extraordinary Expenses").
In order for expenses to count as extraordinary, the occurrence must be truly abnormal and not reasonably expected to recur in the foreseeable future as is the case with a blizzard in Florida. Other examples of extraordinary expenses might include the seizure of assets by a foreign government (if, say, Company XYZ also operated resorts in France, and the French government suddenly seized the assets there) or dramatically adverse legislation (such as the outlawing of beach resorts by the American or French government). Often the company's financial statements will contain footnotes offering additional insight and detail on these expenses.
Usually, determining whether an item is extraordinary is black and white. However, there is some degree of judgment required in the interpretation of "infrequent, unusual, and material in size." In our example, had the blizzard been a hurricane, the related expenses probably would not have qualified as extraordinary items, because hurricanes are very likely to hit Florida during certain times of the year.
Why Does an Extraordinary Item Matter?
The notion behind the extraordinary items accounting treatment is to prevent "once-in-a-lifetime" events from skewing a company's regular earnings. Most analysts and investors add extraordinary items back to the company's reported net income to get a sense of what the company's "real" profitability was. It is important to note, however, that not all investors exclude extraordinary items from their calculations, and this can result in misleading P/E ratios or other measures.
Thus, extraordinary items give companies some leeway, allowing them to sometimes report lower earnings but get credit for higher earnings. Obviously, it is tempting for companies to try to report every bad thing that happens as an extraordinary item. This is why the Accounting Principles Board largely governs the accounting treatment and qualifications of extraordinary items.