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Accounting for "Nonrecurring" Charges

Originally posted on: November 27, 2004

Updated: Dec 10, 2004

In particularly competitive industries, the following situation will commonly occur:

1) A company sees a way to cut costs, by replacing obsolete equipment, or moving a plant to another location, or by some other method.

2) The company incurs an "asset-impairment" charge to write down the capital that is being replaced, and/or a restructuring charge to account for the cost of the new improvements.

3) The company's annual report refers to the asset impairment and restructuring charges as "one-time" or "nonrecurring" costs, and suggests that investors ignore these charges. They also claim that these improvements will lead to significant cost savings, which will cause earnings to grow.

4) Often, these "improvements" will not lead to any cost savings. Occasionally, they will turn out to be disastrous, and will lead to further "restructuring" charges. When the improvements are a success and cost savings are realized, they are typically competed away, and most of the savings are passed on to the company's customers. The company ends up earning a tiny, or non-existent, return on its investment.

5) A few years later, the process repeats itself.

You will often see this when examining the 10-year historical earnings of a company. Analysts will predict that a company will earn, say, $5 per share. But over the past 10 years, the company's earnings (including all nonrecurring expenses) have varied widely, never exceeding $3 per share, and averaging a particularly low number (say, 50 cents per share). It's possible that the company was in a 10-year cyclical downturn, but it's more likely that the company takes a "one-time" charge every year. Analysts ignore these charges in their earnings estimates, leading to the inflated $5 number.

If the company you're looking at is in a weak competitive position, my advice is to avoid this company entirely. Typically, these companies will pay little in dividends, and their retained earnings will be eaten up by "nonrecurring" charges. The typical result is a poor annual return on the stock. However, if the company has strong, sustainable competitive advantages, then these cost-cutting measures will probably improve profits. The company may take a "non-recurring" charge to cut these costs, but most of the savings will go to the company itself, not its customers. I recommend that you look back several years and estimate the average nonrecurring charges that the company takes every year. You should take this number and add a margin of safety, and then deduct this from your estimate of the company's future earnings. This will give you a more accurate picture of the company's earning power.

Another possibility: the "restructuring charges" might be due to previous management. Perhaps the previous CEO made a lot of bad acquisitions, which lead to huge write-downs. If the company has new management, it might be worth investing in, and you might be justified in ignoring these "nonrecurring" charges. In any case, it is important to examine these charges. If you don't, you will be overestimating the company's earning power, and your estimate of the company's value will be too high.