Bookkeeping – Estimating Extraordinary Items (Lesson 87)
The final type of estimating relates to unusual and infrequent items; these are commonly referred to as extraordinary items. Basically, they rarely occur but do happen once or twice over an economic cycle. The following are examples:
* Accidents
* Losses Associated with Natural Disasters
* Fires
* Work Stoppage (Labor Strike, Civil Unrest, Community Events)
* Sale of a Department, Division or an Entire Segment of a Company
* Mergers/Acquisitions
* Write-Down of Assets Notably Goodwill; Research and Development
When these unusual events happen the actual costs are often unknown as it takes several weeks to realize. Accrual accounting requires the matching of revenue and costs associated with this event in the accounting period the item or event occurs. Therefore, the accountant must estimate the costs and any revenue associated with the item. Bookkeeping requires an entry to account for these values.
This lesson explains how to create this estimate by first evaluating the incident and then making the entry.
The entry is not as simple and straight forward as other forms of estimating and a section covers this in detail. Throughout, examples are used that will act as guidelines for you related to the particular type of item/event. Finally, some pointers are offered with how to approach really complicated situations and then, how to book the entry.
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Evaluating Extraordinary and Unusual Items
In almost every unusual event the costs exceed any revenue or proceeds received. Take for example a small auto accident. The insurance proceeds never cover all the associated costs. First off, there is the deductible involved, next are the incidentals including lost time; lost earnings because the asset is not utilized; there is even the cost of waiting to receive the estimate for repairs. It is the job of the accountant to evaluate these costs. I encourage accountants to use a spreadsheet to create a logical flow related to the incident.
Every extraordinary event has obvious and hidden costs related to the event. List both the obvious and the potentially hidden costs in the spreadsheet. Let’s continue with with the accident. Here is my list:
Obvious
(1) Deductible
(2) Government Service Fees (Fire Dept. & Ambulance)
(3) Ticket and Court Costs (Employers make Employees pay This)
(4) Towing
(5) Labor Time to Communicate with Repair Shop
(6) Labor Time to Communicate with Property Owners of Damaged Property
(7) Urinalysis Tests on Employee Driver
(8) Medical Costs Related to Injury of Driver (If Not Covered by Auto Policy)
(9) Replacement of Lost Tools/Damaged Materials Etc.
(10) Legal Fees to Address or Defend Potential Lawsuits
(11) Court Fees Related to Potential Lawsuits
Hidden
(1) Additional Amounts Beyond Insurance Proceeds to Replace Vehicle if a Total Loss
(2) Medical Costs for Injured Parties not Covered by Insurance
(3) Counseling Costs for Employee Driver
(4) Retraining Expenses for Driver
(5) Costs of Repair in Excess of Insurance Proceeds and Deductible
(6) Increase in Future Insurance Premiums
(7) Environmental Damage (Fuel/Oil Spill, Hydraulic Fluid Clean-Up)
(8) Impact from Negative Publicity
(9) Lawsuit Outcome Not Covered by Insurance
When a spreadsheet is created, each item is identified and a corresponding probability is evaluated with notes. For example, using the above, look at item two under hidden costs. From the accident report, a child was injured and taken to the hospital for lacerations to the face and bruises. The child was released later that day. How would you evaluate this line item? Look at this approach:
Item Description Costs Est. Cost Ins. Proceeds Diff Probability
H2 Child to Hospital Emergency Room, $7,000 $5,000 $2,000 75%
Lacerations & Surgery, Pharmaceuticals, Ins. Max
Bruises Bandages
The potential liability equals $1,500. After reading the insurance policy, the accountant discovers that immediate medical coverage is $5,000 leaving an unpaid balance (estimated) of approximately $2,000. The probability percentage is the estimate of the most likely chance costs for the emergency room visit will reach the estimated dollar value of $7,000. Therefore, there is a 75% chance that the uncovered difference of $2,000 will have to be paid. That dollar value is calculated at $1,500 ($2,000 * .75).
Each item is determined in a similar manner. It is important to update the spreadsheet daily from current (most recently received) information. Sometimes the accountant has to make phone calls to get accurate information and monetary dollar values related to each item. Most likely, all items will be identified within 30 to 60 days of the incident.
It is common to delay the release of that accounting period’s financial performance until more information is known in order to accurately estimate the costs in excess of the proceeds related to the incident. This is why it is essential to go 30 days after the incident before reporting that period to accurately determine actual and estimated costs. If the accident happens on the last day of the accounting period, the additional 30 days to receive accurate information will delay reports by 30 days.
This same process is used with all extraordinary and unusual events.
The Accounting Entry
In prior lessons I divided the expenses section out into six major groups as illustrated here:
Expenses
– Management
– Facilities
– Insurance
– Office Operations
– Taxes and Licenses
– Other
Capital costs are typically an expense group but are reported after operational profit (gross profit less expenses). Another group of expenses is included after capital costs and includes extraordinary and unusual items. The income statement (summary format) looks like this:
Revenue $Z,ZZZ,ZZZ
Cost of Sales ZZZ,ZZZ
Gross Profit ZZZ,ZZZ
Expenses
– Management $ZZZ,ZZZ
– Facilities ZZZ,ZZZ
– Insurance ZZ,ZZZ
– Office Operations ZZ,ZZZ
– Taxes & Licenses ZZ,ZZZ
– Other Expenses Z,ZZZ
Sub-Total Expenses ZZZ,ZZZ
Operational Profit ZZZ,ZZZ
Capital Costs $ZZZ,ZZZ
Extraordinary Items ZZ,ZZZ
Sub-Total Capital & Extraordinary ZZZ,ZZZ
Profit Before Taxes ZZ,ZZZ
Taxes ZZ,ZZZ
Net Profit $ZZ ZZZ
Extraordinary items are separated from operational expenses so that there is a consistent ability to compare operational profits from one period to others. If extraordinary items are included in expenses, it will greatly distort operational profit for the respective period and affect comparative reports in the future.
Just like other estimates, an entry is posted (the credit side of the entry) to the balance sheet. Similar to employee benefits and warranties, the credit for extraordinary items is a current liability. It is considered one of the accrued expenses and is in its own sub-account to accrued expenses. The account can have various names including:
(A) Extraordinary Items
(B) One-Time Events
(C) Unique/Issues
(D) Unusual Items
The entry is similar to warranties. The debit for the estimated amount is posted to the expense item ‘extraordinary items’ and the credit is posted to the accrued expenses account. As the money is paid out for the items listed in the spreadsheet, the accrued liability is debited and cash is credited. The key is to continuously update the spreadsheet. It is extremely helpful to delay the financial reports for the accounting period related to the event to ascertain the most accurate estimate of the costs for the event. There is some logic to this. Overestimate the costs and the following accounting periods will report greater profit. Why?
Logic
In accounting it is almost a rule carved in stone to not restate financial reports once those reports are released. Readers of financial information end up with two sets of different dated reports for the same accounting period and do not know which one is accurate. Furthermore, they lose confidence and trust in the preparers of financial statements. When an extraordinary event occurs, delaying the reporting of information is appropriate. It is essential to estimate the event’s cost accurately. To illustrate let’s take the auto accident and report the financial results.
The Accident
One of the company’s employees was driving a company vehicle and t-boned a van occupied by a family of four. The impact sent one child to the hospital for lacerations and bruises. Fortunately, nobody else was injured. A toxic exam on the employee resulted in a high level of THC and the driver was cited for driving under the influence of a narcotic. The employee was fired. The accountant prepared a spreadsheet identifying 35 different line items of costs and spent numerous hours over 30 days calculating the probability and total cost to the company. The auto policy assumed a commanding role in controlling all costs. The underwriter informed management that lawsuits would be negligible as there was contributory negligence related to the van driver.
The accident occurred on the 14th and all bills related to the actual day of the accident are in the accounting department. The total amount paid and estimated remaining is $17,247. The company agreed to pay a retainer of $3,800 to the law firm to address legal matters associated with the outcome of this accident. The updated spreadsheet identifies $22,780 including the actual amount of $17,247 to date, the legal retainer and some unresolved items. The accountant books the entry by debiting extraordinary expense for $22,780 and cash for those amounts paid and the balance to accrued expenses – unusual items.
Two months later, the company receives a bill from the underwriter for a co-share fee related to the government fees exceeding the policy limit that day. The amount is $980. This co-share fee was not anticipated after reviewing the spreadsheet. The financial statements are closed for the month of the incident. How is this booked?
Resolution
If the $980 is booked as a debit to extraordinary items in the expense section, it will appear as if some unusual event occurred in this particular month (2 months later). To avoid misinformation, the accountant actually posts the debit to the accrued expenses – unusual events and credits accounts payable. When the bill is paid, debit accounts payable and credit cash. But now, the accrued expenses account – unusual items has an unexpected debit value in a credit based account. For now, assume that $19,381 of the estimated $22,780 has been paid including the $3,800 to the law firm. Let’s look at the current balance in this ledger.
Ledger – Accrued Expenses/Unusual Items Balance
Z/ZZ/ZZ Estimated cost of event (auto accident) $22,780 $22,780 Credit
Various Amounts paid to various parties (15,581) 7,199 Credit
Z/ZZ/ZZ Amount paid to law firm for retainer #10587 (3,800) 3,399 Credit
Z/ZZ/ZZ Insurance co-share payment for govt. fees (980) 2,419 Credit
The ledger indicates that the company still expects to pay out another $2,419 related to this incident. However the spreadsheet will indicate $3,399 is still owed (the $980 discrepancy). Over the next several months, more payments are made and they are debited to the accrued expenses account so that after six months a grand total of $23,207 was paid including the $980 for the unexpected co-share. The ledger’s balance is a debit value of $427. Remember, liabilities will have a credit balance, debit balances in liabilities are reported with parenthesis on the balance sheet.
Prior to year-end, the law firm closes the case as all waivers are signed and issues a refund of $723 for the balance of the retainer. Furthermore, all follow-ups with the various parties are complete. There will be no more activity related to this accident. The accountant books the refund by debiting cash for $723 and credits accrued expenses – unusual items for the same. The new balance in this ledger is a credit of $296. This means that the total cost of the accident was $22,484 as no other items remain outstanding. The spreadsheet should confirm the final total cost if continuously updated.
Note a couple of interesting accounting issues.
(1) Over on the income statement, only one month, the accounting period of the accident has a charge to it for the cost, not any of the follow-up months. All activity related to the event is then posted to the accrued expense account so that information on the income statement is accurate.
(2) The original dollar amount is an estimate, it wasn’t designed to be accurate. Its accuracy was developed by extending the closing date of the financials in order to assess all information and corresponding costs. Now actual activity of payments and new costs are posted against the estimate which is very similar to employee benefits and warranties. But the question remains as how to address the remaining $296 (credit balance) on the books.
Let’s look back at the totality of the accident. The financial cost was estimated at $22,780 and actual costs were $22,484. This means the year-to-date income statement has expenses overstated by $296. It is improper to assign this value to the current month and it is best to make this adjustment at year-end as a step in the final year-end closing (explained in a future lesson). Suffice it to say that on the last day of the year, accrued expenses – unusual items is debited for $296 and the expense account of extraordinary items will reflect the estimate of $22,780 less $296 for a net of $22,484, the actual amount finally paid out for the accident.
The above illustrates the accounting process involved with an extraordinary item or event. The spreadsheet is an essential guide in all this as it really allows the accountant a chance to see all the details and nuances of an extraordinary item. The following section covers other unusual events in more detail and will explain the complications involved.
Insights to Unusual Events
The following are the various types of unusual events and a snapshot of what to be on the lookout for in terms of costs. If any single event requires an entry, it is explained.
Acts of God
Insurance companies refer to storms, floods, fires and land movement as ‘acts of God’. The accounting concept is similar to the accident illustrated above. Use a spreadsheet to identify the ordinary and obvious but be sure to include:
A) Losses to inventory and fixed assets (equipment, tools, vehicles)
B) Labor costs to clean up and make repairs
C) Additional office time and costs to account for the event
D) Costs related to work in process as often existing work completed must be redone due to damage from the act of God.
The most critical issue actually relates to the company’s inability to continue selling products or performing services. Many insurance companies sell ‘Lost Revenue’ policies that basically pay amounts equal to the gross profit typically generated each day for a designated period. This type of policy can get expensive so most businesses absorb this lost revenue. The easiest and simplest way to handle this is to not record anything related to the event in regards to lost sales. The accounting reports simply have a low or non-existing sales volume for the period of the event. If the business does have a ‘Lost Revenue’ policy, record the revenue by crediting a unique account in revenue and debiting cash.
Closing of a Department/Division/Segment
The closing of a division or department is not an instantaneous event. It often takes months to transpire including finishing up existing contracts or work in process. A division termination is really a two step process. The first step covers actual costs to close out during the physical termination period. It is wise to identify as many outstanding issues during this step and either quantify or pay the value during this period. This reduces the complexity involved in estimating costs in step two.
The second step begins in the final month of the physical termination period. During this period costs that must be paid in the future directly related to the division closing are estimated. Hopefully many of these costs were included during step one above (step one costs are included in either cost of sales or regular expenses). It is during this step that any estimated closing costs are identified as an extraordinary item.
Be sure to include the following as a function of estimated closing costs:
A) Labor Separation/Termination Packages
B) Costs to Dispose/Sell/Reconfigure Fixed Assets from the Division
C) Losses Associated with Disposal of Inventory Assigned to the Division
D) Contractual Penalties
E) Governmental Regulatory Compliance Costs
F) Tail Insurance (Insurance that Protects Historical Issues Claimed in the Future)
Write-Down of Assets
Sometimes assets don’t last as long or the fair market value suddenly decreases as initially anticipated at the time of purchase. Good examples include technology, tooling software and medical equipment. Newer technology makes old technology obsolete. When this happens, the old asset’s dollar value on the books must be adjusted downward to a more realistic value. This is referred to as writing assets down to a fair market value. In small business this is more common with goodwill and research & development costs accumulated as intangible under other assets on the balance sheet.
Fixed assets rarely have this problem in small business due to accelerated depreciation. Write-downs of intangible assets are often triggered by a single event, take goodwill for example.
Goodwill represents amounts paid in excess of the fair market value of the fixed assets acquired. It is essentially the feel good aspect of an item bought that will come back to the business in the future. Goodwill is often destroyed by a single event such as criminal activity, natural disasters or labor disputes. A write-down of this value is necessary.
Unlike traditional accrual to a current liability for this value, the credit portion of the entry is posted directly against the asset on the books adjusting the asset’s value lower to reflect its current fair market value.
Summary – Estimating Extraordinary Items
Extraordinary items are infrequent and unusual events causing financial losses to business. The identification of actual costs for the loss takes time. Any delay of recognizing costs in the future goes against the accrual concept of accounting and therefore the costs must be estimated and applied against the earnings for the accounting period of the event.
Therefore, to increase accuracy of these estimated costs it is prudent to delay the issuing of financial performance for the accounting period. A delay of 30 days is an acceptable time frame.
During the delay use a spreadsheet to identify potential costs, probability of existence and most likely cost to the business. Once a high level of confidence is ascertained for the dollar value of the event, any unpaid balance is posted as an accrued expense to a sub-account titled unusual items. All debits are posted to an expense account called extraordinary items.
After the accounting period is closed, any additional debits or costs than originally estimated are solely adjusted in the accrued liability account. Once all affairs (costs, lawsuits, legal and insurance) are settled, any remaining balance is adjusted to extraordinary items (expense account) as a year-end adjustment. ACT ON KNOWLEDGE.
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