NONRECURRING ITEMS IN THE INVENTORY DISCLOSURES OF LIFO FIRMS




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.

A reduction in the physical inventory quantities of a LIFO inventory is called a LIFO liquidation. With a LIFO liquidation a portion of the firm’s cost of sales for the year will consist of the carrying values associated with the liquidated units. These costs are typically lower than current replacement costs, resulting in increased profits or reduced losses.

As with the differences between the LIFO cost and the replacement value of the LIFO inventory, SEC regulations also call for disclosures of the effect of LIFO liquidations. Handy and Harman had LIFO liquidations in both 1996 and 1997. In line with these SEC requirements, Handy and Harman provided the following disclosure of the effects of these inventory reductions:

Included in continuing operations for 1996 and 1997 are profits before taxes of $33,630,000 and $6,408,000, respectively, from reduction in the quantities of

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NONRECURRING ITEMS IN THE INVENTORY DISCLOSURES OF LIFO FIRMS

precious metal inventories valued under the LIFO method. The after-tax effect on continuing operations for 1996 and 1997 amounted to $19,260,000 ($1.40 per basic share) and $3,717,000 ($.31 per basic share), respectively.

The effect of the Handy and Harman LIFO liquidation is quite dramatic. Including the effects of the LIFO liquidations, Handy and Harman reported after-tax income from continuing operations of $33,773,000 in 1996 and $20,910,000 in 1997. Of the after-tax earnings from continuing operations 57% in 1996 and 18% in 1997 resulted from the LIFO liquidations. Handy and Harman reported benefits from LIFO liquidations for most years between 1991 and 1997.

Although Handy and Harman reported LIFO liquidations with some regularity, an analysis of sustainable earnings should consider the profit improvements from the liquidations to be nonrecurring. The LIFO-liquidation benefits result from reductions in the physical quantity of inventory. There are obvious limits on the ability to sustain these liquidations in future years; as a practical matter, the inventory cannot be reduced to zero. Moreover, the variability in the size of the liquidation benefits argues for the nonrecurring classification. The profit improvements resulting from the LIFO liquidations simply represent the realization of an undervalued asset and are analogous to the gain associated with the disposition of an undervalued investment, piece of equipment, or plot of land.

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A statement user cannot rely on the disclosure requirements of the SEC when reviewing the statements of nonpublic companies, especially where an outside accountant has performed only a review or compilation. However, one can infer the possibility of a LIFO liquidation through the combination of a decline in the dollar amount of inventory across the year and an otherwise unexplainable improvement in gross margins. Details on the existence and impact of a LIFO liquidation could then be discussed with management.



Frequently Asked Questions

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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: 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: 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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