Gains and Losses from Peripheral Activities
Firms often enter into transactions that are peripheral to their core operations but generate gains and losses that must be reported on the income statement. For example, to create, manufacture, and market products, firms generally need to invest in assets such as buildings and equipment. When a firm decides to sell and replace such assets, the sale usually results in a gain or loss. Similar to restructuring charges, gains and losses from activities peripheral to the primary activities of a firm are included in income from continuing operations. You should search for such items and decide whether to exclude them when assessing current profitability and forecasting future earnings. Because gains and losses tend to be generated from sales of long-term assets or extinguishment of long-term liabilities, it is not clear that the change in asset or liability value is related to the current period. For example, a gain on a sale of a building might have been the result of an economic gain from appreciation in a prior period. Or, depreciation in prior years might have been too high because of an unrealistically low useful life estimate. In either case, including the gain to assess current period profitability is not warranted.
Firms report peripheral gains and losses on a pretax basis. Income tax expense includes any tax effects of the gain or loss. If you decide to eliminate the gain or loss from income from continuing operations, you also must eliminate the related tax effect from income tax expense using specific information disclosed about the tax effects or using the statutory rate if the firm does not disclose specific information about the tax effects.
Gains and losses can be recurring, material, and a part of corporate strategy. For example, Exhibit 6.6 shows how Singapore Airlines reported surplus (gains) on disposal of aircraft, spare parts, and spare engines over 2003–2008. Singapore Airlines maintains a reputation for flying newer, technologically advanced aircraft, which results in the use of aircraft for fewer years than other airlines. Thus, the sale of aircraft and spare parts is a significant portion of Singapore Airlines’s profitability and should be treated as recurring when forecasting future earnings.
Restructuring Charges and Impairment Losses
Firms may decide to remain in a segment of their business but elect to make major changes in the strategic direction or level of operations of that business. In many of these cases, firms record a restructuring charge against earnings for the cost of implementing the decision, which might include terminating or transferring employees, closing down certain types of operations, or substantially changing production and sales processes. Employee-related costs from downsizing or employee retraining and reassignment typically make up a substantial portion of restructuring costs.
Firms often enter into transactions that are peripheral to their core operations but generate gains and losses that must be reported on the income statement. For example, to create, manufacture, and market products, firms generally need to invest in assets such as buildings and equipment. When a firm decides to sell and replace such assets, the sale usually results in a gain or loss. Similar to restructuring charges, gains and losses from activities peripheral to the primary activities of a firm are included in income from continuing operations. You should search for such items and decide whether to exclude them when assessing current profitability and forecasting future earnings. Because gains and losses tend to be generated from sales of long-term assets or extinguishment of long-term liabilities, it is not clear that the change in asset or liability value is related to the current period. For example, a gain on a sale of a building might have been the result of an economic gain from appreciation in a prior period. Or, depreciation in prior years might have been too high because of an unrealistically low useful life estimate. In either case, including the gain to assess current period profitability is not warranted.
Firms report peripheral gains and losses on a pretax basis. Income tax expense includes any tax effects of the gain or loss. If you decide to eliminate the gain or loss from income from continuing operations, you also must eliminate the related tax effect from income tax expense using specific information disclosed about the tax effects or using the statutory rate if the firm does not disclose specific information about the tax effects.
Gains and losses can be recurring, material, and a part of corporate strategy. For example, Exhibit 6.6 shows how Singapore Airlines reported surplus (gains) on disposal of aircraft, spare parts, and spare engines over 2003–2008. Singapore Airlines maintains a reputation for flying newer, technologically advanced aircraft, which results in the use of aircraft for fewer years than other airlines. Thus, the sale of aircraft and spare parts is a significant portion of Singapore Airlines’s profitability and should be treated as recurring when forecasting future earnings.
Restructuring Charges and Impairment Losses
Firms may decide to remain in a segment of their business but elect to make major changes in the strategic direction or level of operations of that business. In many of these cases, firms record a restructuring charge against earnings for the cost of implementing the decision, which might include terminating or transferring employees, closing down certain types of operations, or substantially changing production and sales processes. Employee-related costs from downsizing or employee retraining and reassignment typically make up a substantial portion of restructuring costs.
The treatment of restructuring charges in analyzing profitability and assessing earnings persistence is important because recessionary conditions often induce firms to include restructuring charges in their reported earnings for the current period. Whether the recessionary conditions are expected to persist will have a bearing on forecasting.
earnings in the future. Further, restructurings are expected to yield operating efficiencies or strategic benefits, and thus, may be associated with lower future expenses and higher future revenues. Consistent with this value-added characteristic of restructurings, announcements of restructurings are typically associated with stock price increases. Interpreting a particular firm’s restructuring charge is difficult because firms vary in their treatment of these items, as follows.
- Firms that apply accounting principles conservatively (for example, use relatively short lives for depreciable assets, immediately expense expenditures for repairs of equipment, or use shorter amortization lives for intangible assets) have smaller amounts to write off as restructuring charges than those that are less conservative.
- Firms that sidestep proper financial reporting treatment by spreading out restructuring charges to minimize the impact of the restructuring charge on annual earnings often must take restructuring charges for several years to provide adequately for restructuring costs
- Firms that maximize the amount of the restructuring charge in a particular year communicate the ‘‘bad news’’ all at once (referred to as the ‘‘big bath’’ approach) and reduce or eliminate the need for additional restructuring charges in the future. If the restructuring charge later turns out to have been too large, income from continuing operations in a later period includes a restructuring credit that increases reported earnings.
The prevalence of restructuring charges in recent years has prompted standard setters to address these measurement and reporting issues. Although differences between U.S. GAAP and IFRS often caused differences in the timing of the charges in past years, recent revisions to IAS 19 effective January 1, 2013, substantially align the two sets of rules related to restructurings.36 The basic rules are that firms record a restructuring liability on the balance sheet and the associated restructuring charge (an expense) on the income statement when these two conditions are present:
- Management has committed to the restructuring plan and has informed employees of termination benefits.
- Restructuring costs meet the definition of a liability
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