Understanding Business Accounting For Dummies, 2nd Edition (40 page)

Writing down (also called
writing off
) damaged and impaired assets

Changing accounting methods

Correcting errors from previous financial reports

With all these extraordinary losses and gains, how can you distinguish the profit that a business earned from its normal revenue and expense activities from profit caused by other forces entirely? This is one case where accounting rules are actually working
for you,
the non-accountant reader of financial reports.

According to financial reporting standards a business must make these one-time losses and gains very visible in the profit and loss account. So in addition to the normal part of the profit and loss account, which reports normal profit activities, a business with unusual, extraordinary losses or gains must add a second layer to the profit and loss account to report on
these
happenings.

If a business has no unusual gains or losses in the year, its profit and loss account ends with one bottom line, usually called
net incom
e or
profit/loss for the period
. When a profit and loss account includes a second layer, that line becomes
net income from continuing operations before unusual gains and losses.
Below this line, those unusual gains and losses appear for each significant, non-recurring gain or loss.

Say that a business suffered a relatively minor loss from quitting a product line and a very large loss from adopting a new accounting standard. Here's what the second layer of this business's profit and loss account looks like:

Net income from continuing operations +267,000,000

Discontinued operations, net of applicable income taxes -
20,000,000

Earnings before cumulative effect of changes in accounting principles +247,000,000

Cumulative effect of changes in accounting principles, net of applicable income taxes -
456,000,000

Net earnings (loss)
-209,000,000

What new accounting standards could possibly cause a £456 million charge? A very likely scenario could be that this charge is the result of the Accounting Standards Board (ASB) changing the way a business records benefits to retired employees. This business probably hadn't been recording those benefits all along, while the employees were still working (see Chapter 13 for more about recording these kinds of future expenses). For a mature business with many retired employees, the accumulated cost for those benefits could quite conceivably reach that high.

The gains and losses reported in the second layer of the external profit and loss account are generally complex and are not always fully explained in the financial report. So where does that leave you? As we advise in Chapter 14, your best bet is to seek the counsel of expert financial report readers - financial reports are, for all practical purposes, designed for an audience of stockbrokers, sophisticated readers of
The Financial Times,
and the like, so don't feel bad that you can't understand a report without a degree in accounting-ese.

Even if you have someone else analyse a two-layer profit and loss account for you, you should be aware of controversial issues that extraordinary losses or gains raise. To really get some respect from your stockbroker or from Joe in Accounting, ask these questions about an unusual loss that a business reports:

Were the annual profits reported in prior years overstated?

Why wasn't the loss recorded on a more piecemeal and gradual year-by-year basis instead of as a one-time charge?

Was the loss really a surprising and sudden event that could not have been anticipated?

Will such a loss occur again in the future?