What are Non-Recurring Items?
Non-Recurring Items are gains and losses recognized on the income statement that must be adjusted, as they are neither part of ongoing core operations nor an accurate reflection of future performance.
Non-Recurring Items: Financial Statement Adjustments
The act of “scrubbing” refers to adjusting financial data for non-recurring items to ensure the company’s cash flows and metrics are normalized to depict its actual ongoing operating performance.
- Recurring Items → Income and Expenses Likely to Continue
- Non-Recurring Items → One-Time Income and Expenses Unlikely to Continue
Public companies must file their financial statements — i.e. the income statement, cash flow statement, and balance sheet — following rules established under Generally Accepted Accounting Principles (GAAP).
But while GAAP attempts to standardize financial reporting in a fair, consistent way with as much transparency as possible, there are still imperfections in certain areas where discretion is necessary.
Understanding the historical performance of a business is critical for forecasting its future performance, since past performance impacts forward-looking assumptions.
Non-Recurring Items: Common Examples
Common examples of non-recurring items are defined in the chart below.
|Impairments (Write-Downs / Write-Offs)||
|Gains / (Losses) on Sale of Assets||
|Employee Severance Packages||
|Income / (Expenses) from Discontinued Operations||
|Mergers & Acquisitions (M&A) Fees||
|Accounting Policy Changes||
Identifying Non-Recurring Items in Financial Reports
The starting point should be the income statement, where significant non-recurring items are often plainly recorded.
But certain line items are often embedded within other line items, so a more in-depth review is necessary into sections such as:
- Management, Discussion, and Analysis (MD&A)
- Footnotes to Financial Statements
The following terms can be searched for within the filings to be directed toward the right sections.
If there is enough time, earnings calls could also be consulted, but in most cases, the financial statements supplemented with the earnings press release and shareholder presentation are sufficient.
Forward-looking guidance by management on a pro forma basis can sanity check your adjustments, but be mindful of how management is incentivized to present their financials in the best possible light.
Industry knowledge is a necessary prerequisite to adjust for non-recurring expenses.
Litigation fees in the pharmaceutical industry are very common, for example, as patient disputes and patent lawsuits are a frequent occurrence (i.e. research and development (R&D) spending comes with substantial risks).
Equity analysts must question if such expenses are a normal occurrence within the pharmaceutical industry and consider the likelihood of these sorts of expenses reappearing in the future.
But many adjustments are subjective – so the more important rule is to maintain consistency and make note of discretionary decisions.
That being said, equity research reports can provide insightful commentary on non-recurring items from analysts that cover the specific sector.
Types of Non-Recurring Items in GAAP Accounting
Under U.S. GAAP, there are three distinct categories of non-recurring items:
- Discontinued Operations: The income and expenses from business divisions no longer operating or that underwent a divestiture must be removed.
- Extraordinary Items: These items are determined as both unusual in nature and infrequent in occurrence (e.g. catastrophic site damage caused by a hurricane).
- Unusual or Infrequent Items: These items are either unusual in nature or their occurrence is infrequent but NOT both (e.g. the gains or losses of acquiring equipment by a manufacturing company recognized on a company’s financial statements).
A noteworthy difference between GAAP and IFRS reporting is that IFRS does not approve of the classification of extraordinary items.
Changes in accounting policies must also be disclosed in public company filings with management commentary on the nature of the change, reasons for the change, and differences from prior periods to guide historical adjustments.
Common examples of accounting disclosures are:
- First-in-First-Out (FIFO) or Last-in-First-Out (LIFO)
- Depreciation Method (e.g. Useful Life Assumption of Fixed Asset, Salvage Value)
- Correction of Mistakes in Past Filings
Scrubbing Financials in Comps Analysis
Comps analysis must be performed as close to “apples to apples” as possible, so all non-recurring items must be excluded.
When performing comparable company analysis or precedent transactions analysis, scrubbing the financials of the peer group is an essential step.
If not, the financials are skewed from the inclusion of non-recurring items and can lead to misguided conclusions.
Unadjusted last twelve months (LTM) multiples suffer the distortive impacts caused by non-recurring items, which misrepresents the recurring core operating performance of the company.
Thus, the LTM financials must be scrubbed for non-recurring items to arrive at a “clean” multiple.
Taxes Adjustments of Non-Recurring Items
Non-recurring items can be presented as either pre-tax or after-tax.
- If pre-tax, the elimination of taxable non-recurring items must be accompanied by a tax adjustment, since we cannot remove an item while ignoring the tax impact.
- If post-tax, the non-recurring item is simply ignored, meaning that there is no need to adjust taxes.
- Incremental Tax Expense = $10 Million Add-Back x 20% Marginal Tax Rate = $2 million
As a result, we must deduct the incremental tax expense from the company’s unadjusted GAAP reported net income.