NONRECURRING ITEMS IN THE INCOME STATEMENT
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
components of earnings. Generally accepted accounting principles (GAAPs) determine the structure and content of the income statement. Locating nonrecurring items in the income statement is a highly efficient and cost-effective process. Many nonrecurring items will be prominently displayed on separate lines in the statement. Further, leads to other nonrecurring items, disclosed elsewhere, may be discovered during this process. For example, a line item that summarizes items of other income and expense may include an associated note reference detailing its contents. These notes should always be reviewed—step 5 in the search sequence—because they will often reveal a wide range of nonrecurring items.
Alternative Income Statement Formats
Examples of the two principal income statement formats under current GAAPs are presented below. The income statement of Shaw Industries Inc., in Exhibit 2.4 is single step and that of Toys “R” Us Inc. in Exhibit 2.5 is multistep. An annual survey of financial statements conducted by the American Institute of Certified Public Accountants (AICPA) reveals that about one-third of the 600 companies in its survey use the single-step format and the other two-thirds the multistep.
The distinguishing feature of the multistep statement is that it provides intermediate earnings subtotals that are designed to measure pretax operating performance. In principle, operating income should be composed almost entirely of recurring items of revenue and expense, which result from the main operating activities of the firm. In practice, numerous material nonrecurring items are commonly included in operating income. For example, “restructuring” charges, one of the most common nonrecurring items of the past decade, is virtually always included in operating income.
Shaw Industries’ single-step income statement does not partition results into intermediate subtotals. For example, there are no line items identified as either “gross profit” or “operating income.” Rather, all revenues and expenses are separately listed and “income before income taxes” is computed in a single step as total expenses are deducted from total revenues. However, the Toys “R” Us multistep income statement provides both gross profit and operating income/(loss) subtotals.
Note that Shaw Industries has a number of different nonrecurring items in its income statements. While they vary in size, the following would normally be considered to be nonrecurring: charges related to residential retail operations,
plant closing costs, record-store closing costs, write-down of U.K. assets, the loss on sale of equity investments, and the preopening expenses.
There will usually be other nonrecurring items lurking in other statements or footnotes. Note the approximately $12-million change in the Other expense (income) net balance for the year ending January 2, 1999, compared to the year ending January 3, 1998. Also, there must be something unusual about income taxes in the year ending January 3, 1998. The effective tax rate ($5,586,000 divided by $30,283,000) is only about 18%, well below the 35% statutory federal tax rate for large companies. By contrast, the effective tax rate ($38,407,000 divided by $57,092,000) for the year ending January 2, 1999, is about 67%.
Nonrecurring Items Located in Income from Continuing Operations
Whether a single- or multistep format is used, the composition of income from continuing operations is the same. It includes all items of revenue, gain, expense, and loss except those (1) identified with discontinued operations, (2) meeting the definition of extraordinary items, and (3) resulting from the cumulative effect of changes in accounting principles. Because income from continuing operations excludes only these three items, it follows that all other nonrecurring items of revenues or gains and expenses or losses are included in this key profit subtotal.
The Nature of Operating Income
Operating income is designed to reflect the revenues, gains, expenses, and losses that are related to the fundamental operating activities of the firm. Notice, however, that the Toys “R” Us operating loss for the year ending January 30, 1999, included two nonrecurring charges. These were the asset write-offs and a restructuring charge. While operating income or loss may include only operationsrelated items, some of these items may be nonrecurring. Hence, operating income is not the “sustainable” earnings measure called for in our opening quote from the AICPA Special Committee on Financial Reporting. Even at this early point in the operations section of the income statement, nonrecurring items have been introduced that will require adjustment in order to arrive at an earnings base “that provides a basis for estimating sustainable earnings. “Also be aware that “operating income” in a multistep format is an earlier subtotal than “income from continuing operations.” Moreover, operating income is a pretax measure, whereas income from continuing operations is after tax. A more extensive sampling of items included in operating income is provided next.
Nonrecurring Items Included in Operating Income
Reviewing current annual reports reveals that corporations very often include nonrecurring revenues, gains, expenses, and losses in operating income. A sample of nonrecurring items included in the operating income section of multistep income statements is provided in Exhibit 2.6. As is typical, nonrecurring expenses and losses are more numerous than nonrecurring revenues and gains. This imbalance is due in part to GAAP, which require firms to recognize unrealized losses but not unrealized gains. Moreover, fundamental accounting conventions, such as the historical cost concept and conservatism, may also provide part of the explanation.
Many of the nonrecurring expense or loss items involve declines in the value of specific assets. Restructuring charges have been among the most common items in recent years in this section of the income statement. These charges involve asset write-downs and liability accruals that will be paid off in future years. Seldom is revenue or gain recorded as a result of writing up assets. Further, unlike the case of restructuring charges, the favorable future consequences of a management action would seldom support current accrual of revenue or gain.
There is substantial variety in the nonrecurring expenses and losses included in operating income. Many of the listed items appear closely linked to operations, and their classification seems appropriate. However, some appear to be at the fringes of normal operating items. Examples related to expenses and losses include the flood costs of Argosy Gaming, merger-related charges incurred by Brooktrout Technologies, the embezzlement loss of Osmonics, and the loss on the sale of Veeco Instruments’ leak detection business. Among the gains, the Fairchild and H.J. Heinz gains on selling off businesses would seem to be candidates for inclusion further down the income statement.
Comparing the items included in operating income to those excluded reveals a reasonable degree of flexibility and judgment in the classification of many of these items. In any event, operating income may not be a very reliable measure of ongoing operating performance given the wide range of nonrecurring items that are included in its determination.
Nonrecurring Items Excluded from Operating Income
Unlike the multistep format, the single-step income statement omits a subtotal representing operating income. The task of identifying core or operating income is therefore more difficult. Nonrecurring items of revenue or gain and expense or loss are either presented as separate line items within the listing of revenues or gain and expense or loss, or are included in an “other income (expense)” line. A sampling of nonrecurring items found in the other-income-andexpense category of the multistep income statements of a number of companies is provided in Exhibit 2.7.
A comparison of the items in two exhibits reveals some potential for overlap in these two categories. The first, nonrecurring items in operating income, should be dominated by items closely linked to company operations. The nonrecurring items in the second category, below operating income, should fall outside the operations area of the firm. Notice that there is a litigation charge included in operating income (Exhibit 2.6, Detection Systems) as well as several excluded from operating income (Exhibit 2.7, Advanced Micro Devices, Cryomedical Sciences, and Trimark Holdings). Gains on the sale of investments are found far less frequently within operating income. Firms may avoid
classifying these nonrecurring gains within operating income to prevent shareholders’ unrealistic expectations for earnings in subsequent periods. It is common to see foreign-currency gains and losses classified below operating income. This is somewhat difficult to rationalize because currency exposure is an integral part of operations when a firm does business with foreign customers and /or has foreign operations.
The operating income subtotal should measure the basic profitability of a firm’s operations. It is far from a net earnings number because its location in the income statement is above a number of other nonoperating revenues, gains, expenses, and losses, as well as interest charges and income taxes. Clearly, the range and complexity of nonrecurring items create difficult judgment calls in implementing this concept of operating income. Management may use this flexibility to manage the operating income number. That is, the classification of items either inside or outside operating income could be influenced by the goal of maintaining stable growth in this key performance measure.
Some of the items in Exhibit 2.7 would seem to have been equally at home within the operating income section. An environmental reserve (Champion Enterprises) appears to be closely tied to operations, as are the workforce reduction charges, a common element of restructuring charges (Imperial Holly); the insurance settlement from the tanker grounding (Freeport-McMoRan); and business interruption insurance (Pollo Tropical).
Nonrecurring Items Located below Income from Continuing Operations
The region in the income statement below income from continuing operations has a standard organization and is the same for both the single- and multistep income statement. This format is outlined in Exhibit 2.8. The income statement of AK Steel Holding Corporation, shown in Exhibit 2.9, illustrates this format. Each of the special line items—that is, discontinued operations, extraordinary
items, and changes in accounting principles—along with examples is discussed in the following sections. All of these items are presented in the income statement on an after-tax basis.
The discontinued operations section is designed to enhance the interpretive value of the income statement by separating the results of continuing operations from those that have been or are being discontinued. Only the discontinuance of operations that constitute a separate and complete segment of the business have normally been reported in this special section. The current segment reporting standard, SFAS 131, Disclosures about Segments of an Enterprise and Related Information, identifies the following as characteristics of a segment:
1. It engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise).
2. Its operating results are regularly reviewed by the enterprise’s chief operating decision maker to allocate resources to the segment and assess its performance.
3. Discrete financial information is available.
Some examples of operations that have been viewed as segments and therefore classified as “discontinued operations” are provided in Exhibit 2.10. Most of the discontinued operations that are disclosed in Exhibit 2.10 appear to satisfy the traditional test of being separate and distinct segments of the business. The retail furniture business of insurance company Atlantic American is a good example. The case of Textron is a somewhat closer call. Textron reports its operations in four segments: Aircraft, Automotive, Industrial, and Finance. The disposition of Avco Financial Services could be seen as a product line within the Finance segment. However, it may very well qualify as a segment under the newer guidance of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, previously presented. The treatment of vegetables as a separate segment of the food processor Dean Foods also suggests that there are judgment calls in deciding whether a disposition is a distinct segment or simply a product line and thus only part of a segment.
Income statement items are considered extraordinary if they are both (1) unusual and (2) infrequent in occurrence. Unusual items are not related to the typical activities or operations of the firm. Infrequency of occurrence simply implies that the item is not expected to recur in the foreseeable future.
In practice the joint requirement of “unusual and nonrecurring” results in very few items being reported as extraordinary. GAAPs identify two types of extraordinary transactions the gains or losses from which do not have to be both unusual and nonrecurring. These are (1) gains and losses from the extinguishment of debt and (2) gains or losses resulting from “troubled debt restructurings. “Included in the latter type are either the settlement of obligations or their continuation with a modification of terms.
A tabulation of extraordinary items, based on an annual survey of 600 companies conducted by the American Institute of CPAs, is provided in
Exhibit 2.11. This summary highlights the rarity of extraordinary items under current reporting requirements. Debt extinguishments represent the largest portion of the disclosed extraordinary items. This leaves only from two to five discretionary extraordinary items per year among the 600 companies surveyed.
The small number of gains and losses classified as extraordinary is consistent with their definition. However, this rarity adds to the challenge of locating all nonrecurring items as part of a thorough earnings analysis. Few nonrecurring items will qualify for the prominent disclosure that results from display in one of the special sections, such as for extraordinary items, of the income statement. A sample of discretionary extraordinary items—that is, items not treated as extraordinary by a specific standard—is provided in Exhibit 2.12.
Natural disasters and civil unrest are some of the more typical causes of extraordinary items. The extraordinary gain of American Building Maintenance may appear to fail the criterion of unusual since small earthquakes are
frequent in the Bay Area. However, the magnitude of this quake, at about 7.0 on the Richter scale, was probably enough for it to qualify as both unusual and nonrecurring. Earthquakes of such magnitude have not occurred since the San Francisco quake of 1906. The Mount St. Helens eruption (Weyerhaeuser) was certainly enormous on the scale of volcanic eruptions.
The discretionary character of the definition of extraordinary items combined with the growing complexity of company operations results in considerable diversity in the classification of items as extraordinary. For example, Sun Company (not displayed in Exhibit 2.12) had a gain from an expropriation settlement with Iran. Unlike Phillips Petroleum, however, Sun did not classify the gain as extraordinary. Neither Exxon nor Union Carbide (also not in Exhibit 2.12) classified as extraordinary their substantial losses from what could be seen as accidents related to their operating activities.16 The classifications as extraordinary of gains on the sale of servicing operations by KeyCorp and on a consumer credit portfolio by SunTrust are rather surprising. These two items would seem to fail the unusual part of the test for extraordinary items.
The task of locating all nonrecurring items of revenue or gain and expense or loss is aided only marginally by the presence of the extraordinary category in the income statement, because the extraordinary classification is employed so sparingly. Location of most nonrecurring items calls for careful review of other parts of the income statement, other statements, and notes to the financial statements.
Changes in Accounting Principles
The cumulative effects (catch-up adjustments) of changes in accounting principles are also reported below income from continuing operations (see Exhibit 2.8). Most changes in accounting principles result from the adoption of new standards issued by the Financial Accounting Standards Board (FASB).
The most common reporting treatment when a firm changes from one accepted accounting principle to another is to show the cumulative effect of the change on the results of prior years in the income statement for the year of the change. Less common is the retroactive restatement of the prior-year statements to the new accounting basis. Under this method, the effect of the change on the years prior to those presented in the annual report for the year of the change is treated as an adjustment to retained earnings of the earliest year presented.
As noted previously, in recent years accounting changes have been dominated by the requirement to adopt new generally accepted accounting principles (GAAPs). Discretionary changes in accounting principle are a distinct minority. Examples of discretionary changes would be a switch from accelerated to straight-line depreciation or from the LIFO to FIFO inventory method.
Information on accounting changes in both accounting principles and in estimates is provided in Exhibit 2.13. This information is drawn from an annual survey of the annual reports of 600 companies conducted by the American
Institute of Certified Public Accountants (AICPA). The distribution of adoption dates across several years, especially for SFAS 121, occurs because some firms adopt the new statement prior to its mandatory adoption date. In addition, the required adoption date for new standards is typically for years beginning after December 15 of the year specified. This means that firms whose fiscal year starts on January 1 are the first to be required to adopt the new standard. Other firms adopt throughout the following year.
Most recent changes in accounting principles have been reported on a cumulative-effect basis. The cumulative effect is reported net of tax in a separate section (see Exhibit 2.8) of the income statement. The cumulative effect is the impact of the change on the results of previous years. The impact of the change on the current year, that is, year of the change, is typically disclosed in a note describing the change and its impact. However, it is not disclosed separately on the face of the income statement. An example of the disclosure of both the cumulative effect of an accounting change and its effect on income from continuing operations is provided below:
Effective January 1, 1998, Armco changed its method of amortizing unrecognized net gains and losses related to its obligations for pensions and other postretirement benefits. In 1998, Armco recognized income of $237.5 million, or $2.20 per share of common stock, for the cumulative effect of this accounting change.
Effect on income from continuing operations for the year of change
Adoption of the new method increased 1998 income from continuing operations by approximately $3.0 million or $0.03 per share of common stock.
In analyzing earnings, the effect of an accounting change on the results of previous years will be prominently displayed net of its tax effect on the face of the income statement. However, the effect on the current year’s income from continuing operations appears only in the note describing the change. While not the case for the Armco example, the current-year effect of the change is often large and should be considered in interpreting the performance of the current year in relation to previous years.
Most of the entries in Exhibit 2.13 represent the mandatory adoption of new GAAP. Two statements of position (SOP), SOP 98-1 and 98-5, produced most of the accounting changes in 1998. Statements of position are issued by the AICPA and are considered part of the body of GAAP. The same is true for EITF 97-13. An EITF represents a consensus reached on a focused technical accounting and reporting issue by the Emerging Issues Task Force of FASB. The item listed as SAB 101 is a document issued by the SEC and will continue to cause changes in the timing of the recognition of income by many companies. The single listed FASB statement, SFAS 121, illustrates the multiyear adoption pattern that reflects early adopters in 1995, followed by mandatory adopters in subsequent years.
Some of the items listed in Exhibit 2.13 represent changes in accounting estimates as opposed to accounting principles. Changes in depreciation method are changes in accounting principle, whereas changes in depreciable lives are changes in estimate. The accounting treatments of the two different types of changes are quite different. Changes in accounting estimates are discussed next.
Changes in Estimates
Whereas changes in accounting principles are handled on either a cumulative effect (catch-up) or retroactive restatement basis, changes in accounting estimates are handled on a prospective basis only. The impact of a change is included only in current or future periods; retroactive restatements are not permitted. For example, effective January 1, 1999, Southwest Airlines changed the useful lives of its 737-300 and 737-500 aircraft. This is considered a change in estimate. Southwest’s change in estimate was disclosed in the following note:
Change in Accounting Estimate
Effective January 1, 1999, the Company revised the estimated useful lives of its 737-300 and 737-500 aircraft from 20 years to 23 years. This change was the result of the Company’s assessment of the remaining useful lives of the aircraft based on the manufacturer’s design lives, the Company’s increased average aircraft stage (trip) length, and the Company’s previous experience. The effect of this change was to reduce depreciation expense approximately $25.7 million and increase net income $.03 per diluted share for the year ended December 31, 1999.
The $25.7 million reduction in 1999 depreciation was not set out separately in Southwest’s 1999 income statement, as would be the case if the depreciation reduction resulted from a change to straight-line from the accelerated method. Unlike the case of AK Steel (Exhibit 2.9), there is no cumulative effect adjustment in the Southwest income statement.
Southwest reported pretax earnings of $774 million in 1999. Pretax earnings in 1998 were $705 million. On an as-reported basis, Southwest’s pretax earnings grew by 10% in 1999. Without the $25.7 million benefit from the increase in aircraft useful lives, however, the pretax earnings increase in 1999 would have been only 6%. That is, on a consistent basis Southwest’s improvement in operating results is sharply lower than the as-reported results would suggest. Locating the effect of this accounting change and determining its contribution to Southwest’s 1999 net income is essential in any effort to judge its 1999 financial performance.
Identifying nonrecurring items in the income statement as outlined above is a key first step in earnings analysis; many such items will be located at other places in the annual report. The discussion that follows considers other locations where additional nonrecurring items may be located.