Definition of Extraordinary Event
Every business has a purpose. When an economic transaction occurs that is not a function of this purpose it is recorded as either other expense or revenue. Some of these transactions can be classified as extraordinary meaning the transaction is significant in value and infrequent in nature. Examples of extraordinary events include:
- Sale of a Division
- Sudden Catastrophic Loss due to Nature (Fire, Hurricane, Flood etc.)
- Lawsuit Claim Punitive Damages (Awarded or Assessed)
- Insurance Proceeds from Death of a Key Man
Those transactions that are not a part of business but do not impact the financials significantly (less than 3%) are referred to as unusual and are also recorded to other expenses and/or revenue. Examples of these include:
- Sale of Equipment
- Disposal of Equipment
- Refund or Assessment Related to an Audit
- Back Payment for an Historical Issue
BOTH EXTRAORDINARY AND UNUSUAL TRANSACTIONS ARE NOT A FUNCTION OF THE BUSINESS PURPOSE. EXTRAORDINARY TRANSACTIONS GENERALLY AFFECT THE BOTTOM LINE BY MORE THAN 3%.
Each transaction generally has a revenue aspect and a cost component. The total transaction is recorded with either the gross method or the net method of accounting.
Gross and Net Method
There are two different methods used in accounting to record extraordinary and unusual transactions. Both methods end up with the same result, either a loss or a gain from the transaction.
The gross method is very similar to the traditional accounting entry whereby the revenue is recorded and a separate entry records the cost associated with that revenue. The gross method is used with unusual transactions. As an example:
In this example both the proceeds and the cost of repairs are reported on the income statement down in the section for other expenses and revenue.
The net method only records the result of the transaction. So if we were to use the net method from the example above, we would simple record in other expenses a debit to accident repairs for $1,000 and a credit to cash for the same amount. However, the net method is not sued with unusual transactions. It is strictly used with extraordinary events.
Well the key is the significant amounts of money involved. These larger transactions if recorded via the gross method would catch the attention of the reader of financial statements. The net method combines both the expense and the revenue and the aggregated value is often a lesser value and its impact on the financial statement is reduced. The income statement’s focus is on reporting regular ongoing activities, not extraordinary events. Extraordinary events should be viewed as infrequent but significant in value.
So let’s expand upon our example above.
If the gross method is used, the entry would identify $93,000 of insurance proceeds and $107,000 of replacement costs. This would indeed catch the eye of the reader of financial statements and shift their focus from regular business operations to something that has nothing to do with the business day to day operations.
Now don’t get me wrong, most accountants insert a note to the financial statements explaining the incident and the results using the gross method. This allows the reader to fully understand that this incident was extraordinary.
I encourage bookkeepers to record the details of extraordinary events in a spreadsheet. There should be one tab for each event.
THE GROSS METHOD IS USED WITH UNUSUAL ACTIVITY WHEREAS THE NET METHOD IS STRICTLY USED WITH EXTRAORDINARY EVENTS.
It is important for you to understand where on the income statement this activity is reported.
Chart of Accounts for Other Expenses and Revenue
In Lesson 18 I illustrated the numbering system for the chart of accounts. I excluded the primary digits of 8 and 9 in the expense types of accounts. These two identifiers are reserved for other expenses (primary digit with an 8) and other revenue (primary digit beginning with a 9).
Now some of you are wondering ‘Why not include this with the regular expenses and revenue?’ Remember the focus of the financial report, report the regular and ongoing activities of the business.
In sections 8 and 9, expenses are first revenue last. This is organized this way strictly for consistency. Section 8 follows regular expenses to keep the reader focused on expenses. Also it is more common for both unusual and extraordinary events to generate losses (costs exceed proceeds).
One final not, most accounting software programs sum up the revenue, cost of sales and expenses (sections 6 and 7) and reports the profit or loss as net profit (loss) from regular operations. Then other expenses and revenue are reported beneath this line. Look at the following illustration:
12 Months Ending December 31, 2015
Cost of Sales (1,210,214)
Gross Margin 208,526
Net Profit – Regular Operations 103,216
Other Expenses (14,000)
Net Profit $89,216
Notice the clarity of the results? A reader can distinctly separate regular activities from other issues.
Other expenses and revenue are used to report both unusual and extraordinary events. The gross method of accounting is used to report unusual activity and the net method is strictly designed for extraordinary events. Primary digits 8 and 9 tied to expense accounts are reserved for other expenses and other revenue respectively. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.
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