The term “special situation” is defined as a situation where the calculation of the operating income is likely to be distorted by external factors, special events or unusual circumstances. Once you have an understanding of these situations, there are several actions that can be undertaken to help mitigate any risk that they may bring about. A special situation in finance is called a significant irregularity that has the potential to result in an unexpected increase, decrease, or volatility of cash flows reflecting the company’s financial position. According to BusinessDictionary.com, a significant irregularity can occur when any of the following things happen:
1) Revenue exceeds expenses; 2) Expenses exceed revenue; 3) Income for previous period exceeds or is less than estimated income for current period; 4) Assets are less than liabilities; 5) There are asset write-downs that account for long-term assets totaling greater than 50% of total assets.
Internally generated events such as acquisition and merger activity qualify as both revenues and expenses, making them difficult to separate during analysis.
Examples of Special Situations in business.
An acquisition is the purchase of one company (the target) by another (the acquirer). The acquirer obtains control of the target company’s business and assets, such as its brand name, technology and production facilities.
A disposition is where a business sells off a subsidiary or an asset. The sale of the business interest may be due to a variety of reasons, including financial distress or it may be part of a strategy to expand into new markets.
A restructuring is where you restructure your business operations by simplifying your organization structure or improving efficiency. This can also involve asset sales and dispositions. An acquisition is the purchase of one company (the target) by another (the acquirer). The acquirer obtains control of the target company’s business and assets, such as its brand name, technology and production facilities.
In a situation of significant irregularity, management is expected to take the following actions: 1) Update the accounting system, 2) Make appropriate adjustments in budgeting, 3) Assign responsibility for probable causes to those who had control over the results. The actual causes of these events are often beyond the control of management or external factors.
Sometimes a company might experience a significant irregularity for which they were not prepared. This can be considered a sign of “incorrectness” on behalf of management. An increase in a significant irregularity tends to indicate that there is more risk in future periods and that the company’s risk exposure has increased.
According to International Accounting Standards, significant irregularities are defined under the following guidelines:
- Reported amounts are generally determined on an accrual basis of accounting. If management declares revenue, they may have to record an expense in the same period. If expenses are deemed material in relation to revenue, they may be recorded as an extraordinary loss.
- The accounting treatment of significant irregularities can be determined by analyzing two factors; 1) The facts and circumstances associated with the event (for example, revenue earned or expenses incurred within specified time periods); 2) Previous period experience (for example, same or comparable events in previous periods). This is similar to the special situation rules previously mentioned.
- Management has the option of recording material revenue and expenses as current or non-current. IASB also allows for materiality thresholds, which must be determined by management and disclosed upon assessment of the items above.
IASB places limits on the size and frequency of significant irregular events, such as 25% or greater than three times the expected level of irregular events for a given year. If any event(s) exceed(s) these limits, management must provide an explanation.
An accrual approach to recording income is restricted to revenue and expense items. Generally, companies do not include non-recurring items in the calculation of the annual accrual. IASB states that significant irregular events would normally be reported under the accounting period(s) in which they occurred. However, management may elect to record significant irregularities (known as retention) over a longer period if this provides useful information or reduces any future operating risks. Although this does create additional accounting complexity, it has the benefit of protecting against future losses by mitigating the possibility that an event may occur which could compromise financial performance.
IASB states that a significant irregularity can be accounted for in two ways: 1) Current period treatment- Material revenue and expense items are reported within the period in which they were earned or incurred; 2) Retention – Material revenue and expense items are accrued or reported over a longer period. This option should only be used if the accrual basis of accounting is not appropriate, but disclosure of material amounts is necessary.
- If management elects to retain the material amount, it directs the nature and duration of that retention, along with any decision rules used. The IASB does not set forth any specific conditions which must be met before an amount can be retained.
- If management elects to accrue or report material revenue and expense items over a longer period, it is still necessary to disclose the fact that the amount is being accrued over a longer period.
IASB states that any variance between actual experience and management’s estimates can be treated as significant irregularity if it is material. This depends on the reliability of the information used to estimate expected amounts. The IASB states that management should assume normal conditions will continue unless there are clear reasons to believe otherwise.
One example of an estimate that might be relied upon by management is one which assumes that foreign exchange rates will remain constant at their current levels, although this assumption may not hold true over an extended period of time. Another example would be an estimate that shows an increase in sales due to a particular promotion, which averages out over time.
If management is aware that the estimate is unlikely to occur and it still relies on it, this could result in a significant irregularity in the future. This would be considered normal and customary for companies who intend to record significant irregularity. Transactions can also give rise to estimates, such as estimating the fair value of any assets or liabilities acquired or disposed of in a business combination. In order to properly account for potential transactions, management must assess all relevant data and consider its reliability before making final estimates.
When assessing the reliability of information used to make estimates, one must consider the following:
1) Known and estimated amounts: Known amounts include all amounts that had been previously identified and recorded under a previous accounting policy. Estimated amounts include any estimates of future events. If management cannot verify the results of its evaluation process, it must disclose this fact and how it arrived at its estimate.
2) Known and estimated sources: Management must disclose known sources such as competitors’ prices or government regulations if they are relevant to their estimates. All other known sources, such as forecasts from financial analysts must be disclosed.
3) Known and estimated bases: Management must disclose any assumptions used to estimate the known amounts if they are not relevant to its estimates. All assumptions should be disclosed.
4) Reasonableness of estimates: Management should consider the following when evaluating the reasonableness of estimates: reliability of underlying information, validity of assumptions, plausibility, frequency of occurrence, degree of accuracy, consistency with other information. If management is unable to evaluate these factors it must disclose this fact in its notes or equivalent disclosure.
5) Updated estimates: The IASB does not give detailed guidance on how often management should update its estimates. However, it does recommend that management update estimates at least annually or whenever there are significant changes in expected amounts. However, the IASB also states that estimated amounts may be updated more frequently if there is a pattern of significant and rapid changes that appear likely to continue (refer to the example of foreign exchange rates referenced above).
If management makes estimates and they prove to be incorrect, this can lead to a significant irregularity. Whether or not this is considered material depends on the size and frequency of such errors. Management should disclose all such errors and any trends (or forecasts) for similar events, as well as any resulting adjustments made to the financial statements.
Another example of a significant irregularity is when management uses estimates instead of actual information. If this information is not reliable, the estimates may also prove to be inaccurate. Management must disclose all facts that are known or reasonably estimated that are relevant to the estimates, along with its basis for judgment.
From the foregoing, it can be deduced that Special situations in business is just as much about the business as it is about ethics. While it is important that these situations are identified and treated specially in order to put the business on a sound footing, failing to do so would also be in contravention of accounting ethics which depending on the prevailing laws, could mean trouble for the business. Issues concerning Special Issues are best handled by proffessionals as they require a very high level of adherence to accounting and business rules. Fintalent, the hiring and collaboration platform for tier-1 M&A and Strategy professionals has a pool of expert Freelance Accounting and Financial Accounting Consultants that are can meet the needs of business owners and help manage Special Situations.