What Are Special Items in Accounting and How Do They Work?

Financial statements often include unusual or one-time transactions that can significantly impact a company’s reported earnings. These are classified as special items, helping investors and analysts separate recurring business performance from exceptional events.

Criteria for Classification

For an item to be considered a special item in accounting, it must be unusual or infrequent. It should not be part of normal operations and should result from events that are not expected to occur regularly.

The Financial Accounting Standards Board (FASB) previously required companies to separately report extraordinary items, but this changed in 2015 with Accounting Standards Update (ASU) 2015-01. Now, special items are disclosed within operating results but must be clearly explained in financial statements.

Companies must provide detailed disclosures, often in footnotes or the management discussion and analysis (MD&A) section of annual reports. The Securities and Exchange Commission (SEC) monitors these reports to prevent misleading financial presentations. Misclassifying a recurring expense as a special item can draw regulatory scrutiny or lead to financial restatements.

Typical Categories

Special items vary by industry and business circumstances but can significantly affect reported earnings. Below are some of the most common types found in financial statements.

Discontinued Operations

When a company sells, shuts down, or disposes of a business segment, the financial results of that segment are classified as discontinued operations. This distinction helps investors assess ongoing business performance without distortion from earnings that will not continue.

Under Generally Accepted Accounting Principles (GAAP), a business segment qualifies as discontinued if it represents a major line of business or geographical area that has been sold or is held for sale. The financial impact is reported separately on the income statement, typically below income from continuing operations. This includes both the operating results of the discontinued segment and any gain or loss from its disposal.

For example, if a retail company sells its European division, all related revenues, expenses, and any profit or loss from the sale would be reported as discontinued operations. This ensures that a one-time transaction does not misrepresent the company’s core financial performance. Investors often exclude discontinued operations when analyzing earnings trends.

Impairment Charges

An impairment charge occurs when a company reduces the value of an asset on its balance sheet because it is no longer worth its recorded amount. This can result from market changes, technological obsolescence, or poor financial performance. Impairment charges are common for goodwill, intangible assets, and fixed assets such as property, plant, and equipment.

Under GAAP, companies must test goodwill for impairment at least annually or when there is evidence of a decline in value. If the fair value of a reporting unit falls below its carrying amount, an impairment charge is recorded. For example, if a company acquires a subsidiary for $500 million but later determines its fair value has dropped to $350 million, it must recognize a $150 million impairment loss.

These charges can significantly impact net income but are non-cash expenses, meaning they do not directly affect cash flow. Investors often adjust earnings metrics, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), to exclude impairment charges when assessing operational performance.

Litigation Expenses

Legal costs can be classified as special items when they involve major lawsuits, regulatory fines, or settlements outside normal business activities. These expenses may arise from product liability cases, antitrust violations, environmental claims, or government investigations.

Companies must disclose material litigation expenses in their financial statements, often in the notes or MD&A section. If a lawsuit is ongoing, accounting rules require companies to estimate and record a liability if a loss is probable and can be reasonably estimated. For example, if a pharmaceutical company expects to settle a class-action lawsuit over a defective drug for $200 million, it must recognize this amount as an expense when the liability becomes likely.

Large legal settlements can distort earnings, so analysts often adjust financial metrics to exclude these costs when evaluating profitability. However, if a company frequently incurs litigation expenses, investors may question whether these costs should be considered part of normal operations rather than special items.

Tax Treatment

Special items can have significant tax implications, as their treatment under the tax code often differs from financial statement presentation. While companies report these items to clarify operational performance, tax authorities assess them based on deductibility rules, timing differences, and applicable tax rates.

A key factor in tax treatment is whether an expense or loss is deductible. The Internal Revenue Service (IRS) generally allows deductions for ordinary and necessary business expenses, but certain special items have restrictions. For instance, fines and penalties paid due to regulatory violations are not tax-deductible. Settlements related to government enforcement actions may be deductible only if the agreement specifies that the payments are compensatory rather than punitive. This distinction affects after-tax earnings and cash flow.

Timing differences between financial reporting and tax treatment also play a role. Depreciation and asset impairments, for example, may be recognized differently for tax purposes. While financial statements require impairment charges when an asset’s value declines, tax deductions for asset write-downs typically follow IRS depreciation schedules. This can create temporary differences between book income and taxable income, leading to deferred tax assets or liabilities. Companies must track these differences carefully to comply with tax regulations while optimizing their tax positions.

Tax rates applied to special items depend on whether they result in ordinary income, capital gains, or non-deductible expenses. If a company sells a business segment, any gain may be subject to capital gains tax rather than the corporate income tax rate, which in 2024 remains at 21% under the Tax Cuts and Jobs Act. Conversely, restructuring costs such as severance payments may be fully deductible, reducing taxable income and lowering overall tax liability. Strategic tax planning helps businesses determine the most advantageous way to structure these transactions.