NONRECURRING ITEMS IN THE STATEMENT OF CASH FLOWS




After the income statement, the operating activities section of the statement of cash flows is an excellent secondary source to use in locating nonrecurring items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of this section of the statement of cash flows results from two factors. First, gains and losses on the sale of investments and fixed assets must be removed from net income in arriving at cash flow from operating activities. Second, noncash items of revenue or gain and expense or loss must also be removed from net income. All cash inflows associated with the sale of investments and fixed assets must be classified in the investing activities section of the statement of cash flows. This classification requires removal of the gains or losses typically nonrecurring in nature from net income in arriving at cash flow from operating activities. Similarly, because many nonrecurring expenses or losses do not involve a current-period cash outflow, such items must be adjusted out of net income in arriving at cash flow from operating activities. Such adjustments, if not simply combined in a miscellaneous balance, often highlight nonrecurring items.

The partial statement of cash flows of Escalon Medical Corporation in Exhibit 2.14 illustrates the disclosure of nonrecurring items in the operating activities section of the statement of cash flows. The nonrecurring items would appear to be (1) the write-down of intangible assets, (2) the net gain on sale of the Betadine product line, (3) the net gain on the sale of the Silicone Oil product

NONRECURRING ITEMS IN THE STATEMENT OF CASH FLOWS

line, and (4) the write-down of patent costs and goodwill. The Escalon income statement also disclosed, on separate lines, each of the nonrecurring items revealed in the operating activities section, with the exception of the intangible assets write-down.

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The asset write-downs, items (1) and (4) above, are added back to net income or loss because they are noncash. The gains on the product-line sales are deducted from net income or loss because all cash from such transactions, including the portion represented by the gain, must be classified in the investing activities section of the cash flow statement. As the gains are part of net income or loss, a failure to remove them would both overstate cash flows from operating activities and understate investing cash inflows.

Examples of nonrecurring items disclosed in the operating activities section of a number of different companies are presented in Exhibit 2.15. Frequently, nonrecurring items appear in both the income statement and operating activities section of the statement of cash flows. However, some nonrecurring items are disclosed in the statement of cash flows but not the income statement. Exhibit 2.15 provides examples of both types of disclosure.

NONRECURRING ITEMS IN THE STATEMENT OF CASH FLOWS

Interpreting Information in the Operating Activities Section

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The statement of cash flows is an important additional source of information on nonrecurring items. It enables one to detect items that are not disclosed separately in the income statement but appear in the statement of cash flows because of either their noncash or nonoperating character. To realize the diagnostic value of the statement of cash flows, one must determine which items in the operating activities section of the statement of cash flows are nonrecurring. The appearance in the statement of cash flows as merely an addition to or deduction from net income or loss does not signify that the item is nonrecurring. Some entries in this section simply reflect the noncash character of certain items of revenue, gain, expense, and loss. For example, depreciation and amortization are added back to Escalon’s net income or loss (Exhibit 2.14) because they are not cash expenses.20 The two asset write-downs are likewise added back to net income or loss because of their noncash character. However, a separate judgment may also be made that, unlike depreciation, these two items are both noncash and nonrecurring.

Also notice that two different gains on sales of product lines are deducted in arriving at operating cash flow. It would be tempting to assume that these are noncash gains. However, the investing activities section of the Escalon statement of cash flows, a portion of which is included in Exhibit 2.16, reveals this not to be the case. Cash inflows of $2,059,835 and $2,117,180 from the sales of Betadine and Silicone Oil, respectively, are disclosed in cash flows from investing activities. The gains are fully backed by cash inflows, but they are deducted from net income because they are not considered a source of operating cash flow. Whatever the specific basis for deducting these gains from net income to arrive at cash flow from operating activities, the process of deduction simultaneously discloses these nonrecurring items.

Two other items in Escalon’s operating activities section (Exhibit 2.14) require comment. First, the addition to the 2000 net loss of $33,382 for “equity in net loss of joint venture” is required because of the noncash nature of this loss. GAAPs require that a firm (the investor) with an ownership position that permits it to exercise significant influence over another company (the investee) short of control must recognize its share of the investee’s results. This principle caused Escalon to recognize its share of its investee’s loss in 2000. However, there is no cash outflow on Escalon’s part associated with simply recognizing this loss in its income statement. Therefore, the addition of the loss to net income simply reflects its noncash character. Determining whether the loss is nonrecurring would require an examination of the income statement of the underlying investee company.

The second item is the $75,000 of “income from license of intellectual laser property.” This item is deducted from 1998 net income in arriving at

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NONRECURRING ITEMS IN THE STATEMENT OF CASH FLOWS

operating cash flow. This deduction may indicate either that no cash was collected in connection with recording this income or that the income is not considered to be an operating cash-flow item. The absence of a cash inflow is the more likely explanation. But should the $75,000 be seen as nonrecurring? If this were a one-time licensing fee, then it should be treated as nonrecurring in evaluating the $171,472 of 1998 net income. Escalon has a substantial net-operating-loss carryforward, and its 1998 pretax and after-tax results are the same. As a result, this $75,000 of income amounted to 44% of Escalon’s 1998 net income. The absence of this item in the cash flows statement in either 1999 or 2000 gives the licensing fee the appearance of being nonrecurring.



Frequently Asked Questions

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Ans: An examination of the income statement, the first step in the search sequence, requires an understanding of the design and content of contemporary income statements. This knowledge will aid in the location and analysis of nonrecurring view more..
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Ans: 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 constitutes a nonrecurring item and (2) if most nonrecurring items were prominently displayed on the face of the income statement. view more..
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Ans: Defining nonrecurring items is difficult. Writers often begin with phrases like “unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in their popular intermediate accounting text use the term irregular to describe what most statement users would consider nonrecurring items. view more..
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Ans: After the income statement, the operating activities section of the statement of cash flows is an excellent secondary source to use in locating nonrecurring items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of this section of the statement of cash flows results from two factors. First, gains and losses on the sale of investments and fixed assets must be removed from net income in arriving at cash flow from operating activities. Second, noncash items of revenue or gain and expense or loss must also be removed from net income. view more..
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Ans: The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17. view more..
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Ans: Income tax notes are among the more challenging of the disclosures found in annual reports. They can, however, be a rich source of information on nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires a focus on a single key schedule found in the standard income tax note. The goal is simply to identify nonrecurring tax increases and decreases in this schedule. view more..
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Ans: An “other income (expense), net,” or equivalent line item is commonly found in both the single- and multistep income statement. In the case of the multistep format, the composition of other income and expenses is sometimes detailed on the face of the income statement. In both the multi- and single-step formats, the most typical presentation is a single line item with a supporting note. Even though a note detailing the contents of other income and expense may exist, companies typically do not specify its location. Other income and expense notes tend to be listed close to the end of the notes to the financial statements view more..
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Ans: Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is an annual and a quarterly Securities and Exchange Commission reporting requirement. Provisions of this regulation have a direct bearing on the goal of locating nonrecurring items. As part of the MD&A, the SEC requires registrants to: view more..
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Ans: Typically, most material nonrecurring items will have been located by proceeding through the first six steps of the search sequence in Exhibit 2.3. However, some additional nonrecurring items may be located in other notes. Nonrecurring items can surface in virtually any note to the financial statements. We will now discuss three selected notes that frequently contain other nonrecurring items: notes on foreign exchange, restructuring, and quarterly and segment financial data. Recall that inventory, income tax, and other income and expense notes have already been discussed in steps 3 to 5. view more..
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Ans: The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted to the reporting of other comprehensive income. This is a relatively new feature of the income statement and was introduced with the issuance by the FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the standard is to expand the concept of income to included selected items of nonrecurring revenue, gain, expense and loss. Under the new standard, traditional net income is combined with a new component, “other comprehensive income,” to produce a new bottom line, “comprehensive income.” view more..
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Ans: The work to this point has laid out important background but is not complete. Still required is a device to assist in summarizing information discovered on nonrecurring items so that new measures of sustainable earnings can be developed. We devote the balance of this chapter to introducing a worksheet specially designed to summarize nonrecurring items and illustrating its development and interpretation in a case study. view more..
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Ans: The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions on completing the worksheet follow: 1. Net income or loss is recorded on the top line of the worksheet. 2. All identified items of nonrecurring expense or loss, which were included in the income statement on a pretax basis, are recorded on the “add” lines provided. view more..
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Ans: The sustainable earnings base provides earnings information from which the distorting effects of nonrecurring items have been removed. Some analysts refer to such revised numbers as representing “core” or “underlying” earnings. Sustainable is used here in the sense that earnings devoid of nonrecurring items of revenue, gain, expense, and loss are much more likely to be maintained in the future, other things equal. Base implies that sustainable earnings provide the most reliable foundation or starting point for projections of future results. The more reliable such forecasts become, the less the likelihood that earnings surprises will result. Again, Phillips Petroleum captures the essence of nonrecurring items in the following: view more..
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Ans: This case example of using the SEB worksheet is based on the 1997 annual report of Baker Hughes Inc. and its results for 1995 to 1997. The income statement, statement of cash flows, management’s discussion and analysis of results of operations (MD&A), and selected notes are in Exhibits 2.27 through 2.34. Further, to reinforce the objective of efficiency in financial analysis, we adhere to the search sequence outlined in Exhibit 2.3. view more..
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Ans: The nonrecurring items located in the Baker Hughes annual report are enumerated in the completed SEB worksheet in Exhibit 2.35. Each of the nonrecurring items is recorded on the SEB worksheet. When an item is disclosed for the first, second, third, or fourth time, it is designated by a corresponding superscript view more..
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Ans: The construction of an SEB worksheet always requires a judgment call. One could, of course, avoid all materiality judgments by simply recording all nonrecurring items without regard to their materiality. However, the classification of items as nonrecurring, as well as on occasion their measurement, calls for varying degrees of judgment. Some examples of Baker Hughes items that required the exercise of judgment, either in terms of classification or measurement, are discussed next. view more..
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Ans: An estimation of the sustainable portion of earnings should be the centerpiece of analyzing business earnings. This task has become a far greater challenge over the past decade as the number of nonrecurring items has increased dramatically. This explosion has been driven by corporate reorganizations and associated activities. Some of the labels attached to these producers of nonrecurring items are restructuring, rightsizing, downsizing, reengineering, redeployment, repositioning, reorganizing, rationalizing, and realignment. view more..
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Ans: Abigail Peabody was a very well-known nature photographer. Over the years she had had a number of best-sellers, and her books adorned the coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment report and wondering why she was not better prepared. After all, she had been featured in the Sunday New York Times book section, had discussed her works with Martha Stewart, and had been the keynote speaker at the Audubon Society’s annual fund-raiser. She knew it was not her investment advisers’ fault. Their performance over the past years had been better than many of the market indixes. She wondered if she was just a poor businessperson. view more..




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