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
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.
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.
Interpreting Information in the Operating Activities Section
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.
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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
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.