Non-Recurring Items

Industry-Specific Adjustments

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:

1. Discontinued Operations: The income and expenses from business divisions no longer operating or that underwent a divestiture must be removed.
2. Extraordinary Items: These items are determined as both unusual in nature and infrequent in occurrence (e.g. catastrophic site damage caused by a hurricane).
3. 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.

As for forward multiples, i.e. next twelve months (NTM) multiples, the projected financials used to calculate the multiples should already be adjusted.

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.

For example, if adjusting for restructuring charges of $10 million in the operating expenses section, the charge is added back to calculate adjusted EBIT (and adj. EBITDA).

Since the restructuring charge is pre-tax, the incremental tax expense on the $10 million add-back must be subtracted for post-tax metrics, namely net income and earnings per share (EPS).

If we assume a 20% marginal tax rate, the tax expense adjustment is the add-back multiplied by the tax rate, which comes out to $2 million.

• 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.