Tiếng anh chuyên ngành kế toán part 8

58
Understanding the Numbers
operating cash flow. This deduction may indicate either that no cash was col-
lected in connection with recording this income or that the income is not con-
sidered 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.
NONRECURRING ITEMS IN THE INVENTORY
DISCLOSUR ES 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.
22
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 liq-
uidated 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 ef-
fect of LIFO liquidations.

23
Handy and Harman had LIFO liquidations in both
1996 and 1997. In line with these SEC requirements, Handy and Harman pro-
vided 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
EXHIBIT 2.17 LIFO inventor y valuation differences: Handy and Harman
Inc. inventory footnote, years ended December 31
(in thousands).
1996 1997
Precious metals stated at LIFO cost $24,763 $ 20,960
LIFO inventory—excess of year-end market value over LIFO cost 97,996 106,201
SOURCE
: Data obtained from Disclosure Inc., Compact D/SEC: Corporate Information on Public Com-
panies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998).
Analyzing Business Earnings
59
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.
24
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 Har-
man reported benefits from LIFO liquidations for most years between 1991
and 1997.
Although Handy and Harman reported LIFO liquidations with some reg-
ularity, an analysis of sustainable earnings should consider the profit improve-

ments 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.
25
Moreover, the variability in
the size of the liquidation benefits argues for the nonrecurring classification.
The profit improvements resulting from the LIFO liquidations simply repre-
sent the realization of an undervalued asset and are analogous to the gain asso-
ciated with the disposition of an undervalued investment, piece of equipment,
or plot of land.
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.
26
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 im-
pact of a LIFO liquidation could then be discussed with management.
27
NONRECURRING ITEMS IN THE INCOM E TAX NOTE
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 non-
recurring items. Fortunately, our emphasis on the persistence of earnings re-
quires 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.
The key source of information on nonrecurring increases and decreases in
income taxes is a schedule that reconciles the actual tax expense or tax benefit

with the amount that would have resulted if all pretax results had been taxed at
the statutory federal rate. This disclosure for Archer Daniels Midland Com-
pany (ADM) is presented in Exhibit 2.18.
Notice that ADM’s effective tax rate is reduced in 2000 by 17 percentage
points as a result of redetermining taxes in prior years. This percentage reduc
tion
60
Understanding the Numbers
is expressed in terms of the relationship of the tax reduction to income from
continuing operations before taxes. ADM’s 2000 pretax income from continu-
ing operations is $353,237,000 and its total tax provision was $52,334,000. The
2000 effective tax rate, disclosed in Exhibit 2.18, is derived by dividing the
total tax provision by income from continuing operations before taxes:
$52,334,000 divided by $353,237,000 equals 14.8%.
The dollar, as opposed to percentage tax savings, is found by multiplying
17% times the 2000 pretax earnings: $353,237,000 × 0.17 = $60 million. ADM
explained that “The decrease in income taxes for 2000 resulted primarily from
a $60 million tax credit related to a redetermination of foreign sales corpora-
tion benefits and the resolution of various other tax issues.”
28
ADM had a dis-
pute with tax authorities over taxes for previous years, and it won. While there
may be some ongoing benefit from this outcome, the $60 million should be
viewed as nonrecurring in evaluating ADM’s earnings performance. Ongoing
tax savings from its foreign sales corporations will continue to be realized and
will be reflected in the reduced level of the ADM effective tax rate.
ADM’s 1998 effective tax rate was also increased by 1.4 percentage points
as a result of fines and litigation settlements being deducted in arriving at pretax
earnings. For income tax purposes, however, these amounts are not deductible,
which means that unlike most other expenses these fines and settlements reduce

after-tax earnings by the full amount of the expenses. There are no associated in-
come tax savings, and the 1.4-percentage-point increase in the effective tax rate
for 1998 is due to the nondeductible character of the litigation settlements and
fines. The nonrecurring item in this case is simply the total of the fines and set-
tlements. The tax benefit not realized because of the nondeductibility of the
fines and settlements is not a separate nonrecurring item.
ADM’s net income increased from about $266 million in 1999 to about
$301 million in 2000. Without the $60 million nonrecurring tax benefit, ADM’s
2000 net income would have declined to $241 million: $301 million − $60 mil-
lion = $241 million. Identifying and adjusting 2000 earnings for this nonrecur-
ring tax benefit results in a far different message: a decline in earnings in
contrast to the reported increase.
EXHIBIT 2.18 Reconciliation of statutory and actual federal tax rates:
Archer Daniels Midland Company, years ended June 30.
1998 1999 2000
Statutory rate 35.0% 35.0% 35.0%
Prior years tax redetermination — — (17.0)
Foreign sales corporation (4.7) (4.5) (6.3)
State income taxes, net of federal benefit 2.4 2.2 2.7
Indefinitely invested foreign earnings 0.7 (1.8) (0.3)
Litigation settlements and fines 1.4 — —
Other (1.0) 2.1 0.7
Effective rate 33.8% 33.0% 14.8%
SOURCE
: Archer Daniels Midland Company, annual report, June 2000, 32.
Analyzing Business Earnings
61
The benefit from the tax redetermination is clearly a nonrecurring item.
The tax reductions due to the foreign sales corporation feature of the tax law may
or may not be sustainable. Any profit component that relies on a specific feature

of the current tax law should be viewed as somewhat vulnerable. That is, its con-
tinuance requires that (1) this feature of the tax law be preserved and (2) that
ADM continues to take the actions necessary to earn these tax benefits.
The ADM disclosures provide one example of a nonrecurring tax benefit
plus at least one example of a benefit that may be somewhat more vulnerable
than other sources of operating profit. Exhibit 2.19 provides a sampling of
other nonrecurring tax benefits and tax charges that were found in recent com-
pany tax notes.
The tax benefits of both Biogen and Dana result from utilizing loss carry-
forwards whose benefits had not previously been recognized. The losses that
produced the tax savings originated in earlier periods. Because the likelihood
of their realization was not sufficiently high, the potential tax savings of the
losses were not recognized in the income statements in the years in which
these losses were incurred. The subsequent realization of these benefits occurs
when the operating and capital loss carryforwards are used to shield operating
earnings and capital gains, respectively, from taxation. These benefits should
be treated as nonrecurring in analyzing earnings performance for the year in
which the benefits are realized.
Gerber Scientific’s effective tax rate was reduced as a result of its recog-
nizing benefits from research and development tax credits. This feature of the
tax law is designed to encourage R&D spending. As with all other tax credits,
continuation of this source of tax reduction requires that the feature continue
to be part of the tax law and that Gerber make the R&D expenditures neces-
sary to earn future benefits.
The nonrecurring items of First Aviation Services and Micron Technol-
ogy both result from adjustments of their tax valuation allowances. The al-
lowance balances represent the portion of tax benefits that have been judged
unlikely to be realized.
29
Increasing this balance will create a nonrecurring tax

EXHIBIT 2.19 Examples of nonrecurring income tax charges
and benefits.
Company Nonrecurring Charge or Benefit
Biogen Inc. (1999) Benefits from net operating loss utilization
Dana Corporation (1999) Capital loss utilization tax benefit
Detection Systems Inc. (2000) Benefit from lower foreign tax rates
First Aviation Services Inc. (1999) Benefit from valuation allowance decrease
The Fairchild Corporation (2000) Benefit from revision of estimate for tax accruals
Gerber Scientific Inc. (2000) Research and development tax credit
M.A. Hanna Company (1999) Benefit from reversal of tax liability—tax settlement
Micron Technology Inc. (2000) Charge for valuation allowance increase
Pall Corporation (2000) Tax benefit of Puerto Rico operations
SOURCES
: Companies’ annual reports. The year following each company name designates the annual re-
port from which the example was drawn.
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Understanding the Numbers
charge; decreasing it, a benefit. The prospects for realization of the tax benefit
must have declined for Micron Technology but improved for First Aviation
Services.
Both the Fairchild Corporation and M.A. Hanna Company tax benefits
were the result of reducing previously recorded tax obligations. Subsequent in-
formation indicated that the liabilities where overstated. The liability reduc-
tion was offset by a comparable reduction in the tax provision. This benefit
should also be viewed as nonrecurring.
Pall Corporation has a tax reduction that is associated with operations lo-
cated in Puerto Rico. In fact, most firms with operations in other countries
produce such tax benefits. Foreign states offer these benefits to encourage
companies, typically manufacturing companies, to locate within their borders.
In many cases these benefits are for a limited period of time, though renewals

are sometimes possible. As a result, while the benefits are real, there remains
a possibility that they will cease at some point. In fact, Pall Corporation dis-
closed just such a change in its income tax note:
The Company has two Puerto Rico subsidiaries that are organized as “posses-
sions corporations” as defined in Section 936 of the Internal Revenue Code.
The Small Business Job Protection Act of 1996 repealed Section 936 of the In-
ternal Revenue Code, which provided a tax credit for U.S. companies with op-
erations in certain U.S. possessions, including Puerto Rico. For companies with
existing qualifying Puerto Rico operations, such as Pall, Section 936 will be
phased out over a period of several years, with a decreasing credit being avail-
able through the last taxable year beginning before January 1, 2006.
This change in U.S. tax law means that previous tax benefits from the opera-
tions in Puerto Rico are not sustainable. When a company reports tax benefits
because of operations in other countries, the possibility that the benefits might
end or be reduced should be considered.
NONRECURRING ITEMS IN THE OTHER INCOME
AND EXPENSE NOTE
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.
The other income and expense note of The Sherwin-Williams Company is
provided in Exhibit 2.20. The balance (income) of the Sherwin-Williams other
income and expense note shows a modest increase between 1997 to 1998 and