Analyzing Business Earnings 39soccer. Temporary increases or decreases in earnings have resulted from ad-
justments to loan loss provisions resulting from economic downturns and sub-
sequent recoveries in the financial services industry. Most recently, there have
been widely publicized problems with tires produced for sports utility vehicles
that will surely create substantial nonrecurring increases in legal and warranty
expenses.
Identifying nonrecurring or irregular items is not a mechanical process;
it calls for the exercise of judgment and involves both line items and as the
period-to-period behavior of individual income statement items.
THE PROCESS OF IDENTIFYING NONRECURRING ITEMS
Careful analysis of past financial performance aimed at removing the effects
of nonrecurring items is a more formidable task than one might suspect. This
task would be fairly simple if (1) there was general agreement on just what con-
stitutes a nonrecurring item and (2) if most nonrecurring items were promi-
nently displayed on the face of the income statement. However, neither is the
case. Some research suggests that fewer than one-fourth of nonrecurring items
are likely to be found separately disclosed in the income statement.^8 Providing
guidance for locating the remaining three-fourths is a key goal of this chapter.
Identif ying Nonrecurring Items:
An Efficient Search Procedure
The search sequence outlined in the following discussion locates a high cumu-
lative percentage of material nonrecurring items and does so in a cost-effective
manner. Search cost, mainly in time spent by the financial analyst, is an impor-
tant consideration. Time devoted to this task is not available for another and,
therefore, there is an opportunity costto consider. The discussion and guid-
ance that follows are organized around this recommended search sequence
(see Exhibit 2.3). Following only the first five steps in this search sequence is
likely to locate almost 60% of all nonrecurring items.^9 Continuing through
steps six and seven will typically increase this location percentage. However,
the 60% discovery rate is higher if the focus is only on material nonrecurring
items. The nonrecurring items disclosed in other locations through steps 6 and
7 are fewer in number and normally less material than those initially found
through the first five.
NONRECURRING ITEMS IN THE INCOME STATEMENT
An examination of the income statement, the first step in the search sequence,
requires an understanding of the design and content of contemporar y income
statements. This knowledge will aid in the location and analysis of nonrecurring