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.

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

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

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.
62
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