Many businesses report unusual, extraordinary gains and losses in addition to their usual revenue, income and, expenses. Recording a gain increases an asset or decreases a liability, while recording a loss decreases an asset or increases a liability. When a business has recorded an extraordinary gain or loss during the period, its income statement is divided into two sections:
- The first section presents the ordinary, continuing sales, income, and expense
operations of the business for the year.
- The second section presents any unusual, extraordinary, and nonrecurring gains and losses that the business recorded in the year.
The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of nowhere, doesn’t happen regularly or often, and can dramatically affect its bottom line profit. In other words, a discontinuity is something that disturbs the basic continuity of its operations or the regular flow of profit-making activities.
Here are six examples of discontinuities or “out of left field” types of impacts:
- Downsizing and restructuring the business. Layoffs require severance pay or trigger early retirement costs; major segments of the business may be disposed of, causing large losses.
- Abandoning product lines. When you decide to discontinue selling a line of products, you lose at least some of the money that you paid for obtaining or manufacturing the products, either because you sell the products for less than you paid or because you just dump the products you can’t sell.
- Settling lawsuits and other legal actions. Damages and fines that you pay — as well as awards that you receive in a favorable ruling — are obviously nonrecurring extraordinary losses or gains (unless you’re in the habit of being taken to court every year).
- Writing down damaged and impaired assets. If products become damaged and unsellable, or fixed assets need to be replaced unexpectedly, you need to remove these items from the assets account. Even when certain assets are in good physical shape, if they lose their ability to generate future sales or other benefits to the business, accounting rules say that the assets have to be taken off the books or at least written down to lower book values.
- Changing accounting methods. A business may decide to use a different method for recording revenue and expenses than it did in the past, in some cases because the accounting rules (set by the authoritative accounting governing bodies) have changed. Often, the new method requires a business to record a one-time cumulative effect caused by the switch in accounting method. These special items can be large.
- Correcting errors from previous financial reports. If you or your accountant discovers that a past financial report had an accounting error, you make a catch-up correction entry, which means that you record a loss or gain that had nothing to with your performance this year.
Every company that stays in business for more than a couple of years experiences a discontinuity of one sort or another. But beware of any business (including your own) that takes advantage of discontinuities in the following ways:
- Discontinuities become continuities. This business makes an
- extraordinary gain or loss a regular feature on its income statement. Every year or so, the business loses a major lawsuit, abandons product lines, or restructures itself. It reports “nonrecurring” gains or losses from the same source on a recurring basis.
- A discontinuity is used as an opportunity to record all sorts of
- A business may just have bad (or good) luck regarding extraordinary events that its managers could not have predicted. If a business is facing a major, unavoidable expense this year, cleaning out all its expenses in the same year so it can start off fresh next year can be a clever, legitimate accounting tactic. But it’s important to know where to draw the line between these accounting manipulations and fraud.
- writedowns and losses. When recording an unusual loss (such as settling a lawsuit), the business opts to record other losses at the same time, and everything but the kitchen sink (and sometimes that too!) gets written off. This so-called big-bath strategy says that you may as well take a big bath now in order to avoid taking little showers in the future.