Item	Company
Inventory purchase prepayment	Apple Computer, Inc. (2003)
Restructuring cost payments	Apple Computer, Inc. (2003)
Outsized distributions from equity investments	Arch Coal, Inc. (2002)
Class action settlement payment	Ascential Software Corp. (2002)
Acquisition-related withholding tax payment	Ball Corporation (2003)
Operating cash flow of discontinued operations	The Beard Co. (2002)
Litigation proceeds	Blue Rhino Corp. (2003)
Litigation settlement payments	Bristol-Myers Squibb Co. (2003)
Outsized increase in receivables and inventory^a	Bulova Corp. (2003)
Outsized restructuring payments	ConocoPhillips (2003)
Security fee reimbursement	Continental Airlines, Inc. (2003)
Foreign exchange gain an loan receivable collection	The Cooper Companies (2003)
Payment of accrued acquisition costs	The Cooper Companies (2003)
Proceeds from business interruption insurance	Cosi, Inc. (2002)
Outsized pension plan contributions	Cox Communications, Inc. (2003)
Stabilization Act compensation	Delta Air Lines, Inc. (2003)
Merger-related charges	Earthlink, Inc. (2002)
Payoff of an equipment lease—not a capital lease	Flowers Foods, Inc. (2003)
Plant closing costs	Flowers Foods, Inc. (2003)
Separation payments	Flowers Foods, Inc. (2003)
Payment of liabilities assumed in an acquisition	GenCorp, Inc. (2003)
Interest collected on tax settlement	Hasbro, Inc. (2002)
Exchange offer payments	Hawk Corp. (2003)
Endorsement fee received	Holiday RV Superstores, Inc. (2002)
Payment of arbitration settlement	Krispy Kreme Doughtnuts, Inc. (2003)
Defamation suit	Mississippi Chemical Corp. (2003)
Interest rate swap termination fees	Newell Rubbermaid, Inc. (2003)
Outsized inventory decrease	Newell Rubbermaid, Inc. (2003)
Income tax paid on long-term contracts^b	Northrop Grumman Corp. (2003)
Contract termination fee received	Oil Dri Corporation of America (2003)
Income taxes refunded	Pacific Security Financial, Inc. (2003)
Avian influenza relief cash from U.S. Government	Pilgrims Pride Corp. (2003)
One-time cash fee received for contract assignment	Sealed Air Corp. (2002)
Cash paid for special items	Storage Technology, Inc. (2002)
Proceeds from insurance claims	Transtech Industries, Inc. (2002)
Outsized income tax payments	The Washington Post Co. (2003)
Payments for tendered stock options	The Washington Post Co. (2003)
^a The term “outsized” indicates payments or receipts that are much higher than recent amounts or that changed at a disproportional rate in relationship to their apparent driver, for example, sales.
^b Northrop Grumman had a $1.2 billion tax payment due to the completion of a long-term contract (B-2 EMD contract) with the U.S. government. This tax had accumulated over a number of years. Northrop Grumman Corp. Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 38

MANAGEMENT IDENTIFICATION OF NONRECURRING OPERATING CASH FLOW

Although in our view the cash flow items listed in Exhibit 6.1 are nonrecurring in nature, we thought that it would be instructive to obtain the views of management regarding non-recurring operating cash flow. We obtained these insights by examining management’s comparative analysis of year-to-year changes in cash flow from operating activities. This analysis typically is presented in the Liquidity and Capital Resources section of the management’s discussion and analysis (MD&A). Although firms may not explicitly identify these items as nonrecurring, the way these items are used in explaining changes in operating cash flow often imply that they are. A sampling of such disclosures is presented in Exhibit 6.2.

The full Kellogg Co. disclosure of the information summarized in the exhibit was presented within its Liquidity and Capital Resources section. The disclosure provided an excellent example of both identifying a nonrecurring operating cash flow item and also indicating its after-tax influence on comparative operating cash flows:

As a result of stronger than expected cash flow in both 2003 and 2002, we made voluntary contributions to several of our major pension and retiree health care plans. The after-tax impact of these contributions reduced cash flow by approximately $37 million in 2003 and $254 million in 2002. After adjusting for these differences, 2003 cash flow was within $40 million of 2002 cash flow, as the higher earnings in 2003 were overshadowed by extremely strong working capital improvements in 2002.⁶

Kellogg adjusted reported operating cash flows in both 2002 and 2003 by adding back, on an after-tax basis, the reduction that resulted from the nonrecurring pension contributions. Making the tax adjustments indicates that these contributions are deductible for tax purposes, either currently or at a future date. Reported operating cash flow was $999.9 million and $1,171.0 million in 2002 and 2003 respectively. The adjusted numbers are $1,253.9 million ($999.9 million plus $254.0 million) in 2002 and $1,208.0 million ($1,171.0 million + $37 million) in 2003. We believe that Kellogg’s adjustment of the discretionary pension contributions out of the company’s reported operating cash flow indicates that management views these contributions as nonrecurring operating cash flow items.

Tax-related payments and refunds are common items to be highlighted by management in explaining changes in operating cash flow. Selected examples in the exhibit include AT&T Corp., Delta Air Lines, Inc., Dole Foods, Inc., Emerson Electric Co., Krispy Kreme Doughnuts, Inc., Steel Cloud, Inc., and Verizon Communications, Inc. Notice that Material Sciences highlights taxes on the sale of an investment. This would be more appropriately classified in investing cash flow to offset the proceeds received on the sale.

Over the last few years, companies often have reported outsized pension plan contributions. These contributions are the product of the decline in the market value of equity securities that resulted in many pension plans becoming underfunded. The combination of these outsized contributions together with a recovery in market values is restoring many firms to a well-funded status. This will bring contribution levels down and in some cases will eliminate them altogether. Management is making efforts to make this point clear to readers of their financial statements.

Exhibit 6.2 Management Identification of Nonrecurring Items of Operating Cash Flow

Source: Information was drawn from 10-K reports to the Securities and Exchange Commission for the year associated with each listed company.

Steel Cloud, listed in the exhibit, disclosed two nonrecurring cash inflows as part of the Liquidity and Capital Resources section in their MD&A. The combination of the tax refund and the outsized growth in unearned revenue accounted for all of its 2002 cash flow from operating activities. The disclosure of these two items is obviously crucial in understanding the change in operating cash flow between 2001 and 2002.

Selected changes in working capital accounts are frequently cited when explaining year-to-year changes in operating cash flow. Conoco Phillips, Emerson Electric Co., The Fairchild Co., and Kennametal, Inc., are examples presented in Exhibit 6.2. Making the nonrecurring determination turns on identifying changes that result from discrete events and not simply changes that are a function of growth or decline in level of business activity. For example, Kennametal notes that “the continued reduction in working capital reflects our initiatives to generate strong cash flow.”⁷

Management identification of what appear to be items of nonrecurring operating cash flow are usually not comprehensive in nature, and the information is seldom organized in such a way that a revised measure of operating cash flow is easily discerned. However, we have located some companies that did provide somewhat more comprehensive revisions of GAAP operating cash flow.

Company Revisions of Cash Flows from Operating Activities

Examples of two companies that revised operating cash flow to remove nonrecurring items are provided. The first, Avon Products, Inc., provided relevant information in text form. The second, Delphi Corp., used a statement format.

Avon Products: Textual Revision of Operating Cash Flow

Avon Products highlights the importance of identifying nonrecurring operating cash flows by disclosing several in the text of the Liquidity and Capital Resources section of its MD&A.

Liquidity and Capital Resources—Cash Flow (in millions)

Net cash provided by operating activities was $182.1 unfavorable to 2001. 2002 results reflect increased U.S. pension plan contributions of $95.0, a tax payment of $20.0 deferred from 2001 and increased cash payments of $35.6 associated with restructuring activities. 2001 results reflect the receipt of a federal income tax refund of $95.2 and the net cash settlement with Sears of $25.9. Excluding these items, net cash from operations was $109.6 higher than the prior year.⁸

Avon does not refer to the above items as nonrecurring. However, their use to facilitate a more meaningful comparison of 2002 to 2001 by developing a revised measure of changes in operating cash flow implies nonrecurring status. Note that on an as-reported basis, 2002 operating cash flow is, as reported by the company, “unfavorable to 2001.” However, after excluding nonrecurring items, 2002 net cash from operations exceeded that in 2001 by $109.6 million. This analysis is consistent with the frequent practice of recasting net income to measures of operating or pro forma earnings.

We summarize the Avon disclosures in Exhibit 6.3. The exhibit is a prelude to a comprehensive worksheet for revising operating cash flow to be introduced in Chapter 7. The worksheet will be used to summarize information on nonrecurring items of operating cash flow and transform reported operating cash flow for each year into sustainable amounts. As noted in the exhibit, Avon’s operating cash flow adjusts for a total of five distinct nonrecurring revision items:

1. An outsized pension contribution

2. A delayed tax payment

3. Increased restructuring payments

4. An income tax refund

5. A settlement payment to Sears

The recasting of Avon’s cash flow data, presented in Exhibit 6.3, requires adding back nonrecurring cash uses and deducting nonrecurring cash sources. Notice that Avon reaches back to 2001 and deducts a tax that was incurred in 2001 but actually paid in 2002. It adds it back to 2002 cash flow. This adjustment is quite different from the others because it involves shifting a cash flow to another period. Shifting the tax cash flow achieves a matching of the tax payment with the taxable income in 2001 that created the tax obligation. Matching is, of course, the central feature of accrual accounting, but it is normally not a characteristic of cash flow presentations. Cash flows normally are reported in the same period as the cash receipts and disbursements. Each of the other adjustment items is simply added to or deducted from as-reported operating cash flow.

The restructuring payments added back in 2002 are identified as “increased” payments. This would fit with the earlier suggestion that some items are treated as nonrecurring based their being irregular in amount. That is, this additional payment level is not expected to continue. The tax refund is deducted in the year received, 2001, because its nonrecurring character inflates the 2001 level of operating cash flow. The increased pension contribution is added back in 2002 because this increased or irregular payment understates 2002 sustainable operating cash flow.

Exhibit 6.3 Revision of Operating Cash Flow to Remove Nonrecurring Items, Avon Products, Inc., Years Ended December 31, 2001, and 2002 ($ millions)

Source: Avon Products, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 35.

The revision of earnings as opposed operating cash flow always makes adjustments for the tax effects, if any, of nonrecurring items. Avon does not make adjustments for tax effects of taxable or tax deductible items. As a result, its cash flow adjustments are overstated. That is, tax effecting with a combined federal and state tax rate of 40 percent reduces the pension adjustment to $57 million ($95 million × .60), the restructuring payments to $21.4 million ($35.6 million × .60); and the Sears settlement to $15.5 million ($25.9 million × .60). The 40 percent combined tax rate is a reasonable approximation of Avon’s marginal federal and state tax rates. Multiplication of the nonrecurring cash flows by 60 percent, or 1 minus the marginal rate of 40 percent, reduces these cash flows to their after-tax amounts. The issue of tax adjustments is discussed further in Chapter 7.

Avon’s motivation for providing information that permits the revising of its operating cash flow would seem to be apparent. The company’s reported cash provided by operating activities declined by $182.1 million between 2001 and 2002. However, Avon believes that this unadjusted comparison obscured the real trend in operating cash flow due to nonrecurring items in both 2001 and 2002. The adjusted data show an increase in cash from operations of $109.6 million. Avon went on to observe that this increase in operating cash flow was due mainly to higher net income.

Delphi Corporation: Schedule Presentation of Adjustments to Operating Cash Flow

Delphi Corporation provides another example of a firm making adjustments to reported operating cash flow. Unlike Avon Products, Delphi presented its data in a schedule or statement format. The company’s reconciliation of reported operating cash flow to a new measure of sustainable operating cash flow is presented in Exhibit 6.4.

The adjustments made to Delphi’s reported operating cash flow include both nonrecurring items of operating cash flow as well as one reclassification adjustment to remove cash flow from the sale of accounts receivable from operations to financing cash flow.⁹ The nonrecurring items include pension contributions, payments related to employee and product line charges, signing bonuses, and separation and initial public offering-related items. The adjustment for sales of accounts receivable is a reclassification adjustment to remove these cash benefits from operations to financing cash flows. The deduction of capital expenditures is typical in the calculation of measures of free cash flow but not operating cash flow.¹⁰

The pension contributions added back in Exhibit 6.4 represent total pension contributions and not outsized amounts. An outsized amount would be the excess of current contributions over more typical amounts. An adjustment for the outsized amount is what one would expect to see in this revision. As was true of Avon Products, tax adjustments are not made in the Delphi revisions. ¹¹

Although items of nonrecurring operating cash flow typically are present in company financials, locating them can be a challenge. Some guidance is provided in the sections that follow.

LOCATING NONRECURRING ITEMS OF OPERATING CASH FLOW

The key to locating items of nonrecurring operating cash flow is first to identify the non-recurring items of revenue, gain, expense, and loss that may have an associated cash flow. Some of our earlier work focused on the income statement and provided guidance on locating nonrecurring items. ¹² This research revealed that a substantial portion of all non-recurring items of revenue, gain, expense, and loss could be located by sequentially reviewing the income statement, statement of cash flows, operating activities section only, other income and expense note, inventory note, and income tax note. Management’s discussion and analysis (MD&A), especially the discussion of comparative operating results, was also a fruitful source of information on nonrecurring items. Of even greater value in terms of the cash flow dimension is the Liquidity and Capital Resources section of the MD&A. Also, in recent years firms increasingly provide notes on restructuring charges that almost always include disclosures of nonrecurring operating cash flows.

Exhibit 6.4 Delphi Corporation, Adjusted Operating Cash Flow, Years Ended December 31, 2001 to 2003 ($ millions)

Source: Delphi Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 7.

After nonrecurring items of revenue, gain, expense, and loss have been located, a second step usually is required to establish if there is an associated cash flow. In some cases, locating nonrecurring items of income and determining their cash flow status will take place simultaneously. For example, the description of a nonrecurring item may make it clear that there is neither a current nor a future associated cash flow. An inventory write-down, like all asset write-downs, is a noncash item, and no additional search to locate an associated cash flow is necessary.

The items presented in the next sections are all nonrecurring or nonoperating items of cash flow.

Income Statement

Income statements often disclose the presence of nonrecurring items, a sampling of which is presented here. With each item, it is also necessary to determine whether there is a past, current, or future cash inflow or outflow. Detailed guidance on the process of determining cash flow status is presented later. Some limited commentary also will be provided in some of the case examples that follow.

ResMed, Inc.: Donations to Research Foundation

ResMed, Inc., reports a $2.3 million deduction for “Donations to Research Foundation” in 2002.¹³ This charge is included in the operating expense section of the ResMed income statement. There is a charge in 2002, but none in either 2001 or 2003. The item appears to be nonrecurring. Detailed attention to determining if there is an associated cash flow is provided in a subsequent section. However, in this particular case one can infer that cash was paid in 2002 because of the absence of an addition to net income for a noncash “Donation to Research Foundation.”

Timco Aviation Services: Gain on Extinguishment of Debt

Timco Aviation Services disclosed a $27.3 million gain as a result of the retirement of debt.¹⁴ Most analysts would consider this gain to be nonrecurring. However, it is not a nonrecurring item of operating cash flow. The gain does have an associated cash flow, but this cash outflow, which was the payment required to retire the debt, was classified in the financing activities section of the statement of cash flows.

Continental Airlines, Inc.: Security Fee Reimbursement and Stabilization Act Grant

Continental Airlines, Inc., disclosed nonrecurring items in both its 2001 and 2003 income statements. The items were related to September 11, 2001, and its aftermath. The 2001 income statement disclosed a $417 million Stabilization Act Grant and the 2003 income statement a $176 million Security Fee Reimbursement.¹⁵ Actual receipts in 2001 from the $417 million Stabilization Act Grant were $354 million.¹⁶ A footnote disclosure in the 2003 Continental annual report stated that “in May 2003, we received and recognized in earnings $176 million in cash from the United States government pursuant to the Emergency Wartime Supplemental Appropriations Act enacted in April 2003.”¹⁷ In each case, these nonrecurring cash receipts were included in operating cash flow.

The difference between the $417 million benefit recognized in the 2001 income statement and the actual amount collected during the year of $354 million highlights the need to often go beyond the income statement to determine the amount and timing of associated cash flow.

Techne Corp.: Litigation Settlement

Techne displayed a $17.5 million litigation settlement on the face of its 2002 income statement. The charge was listed among its operating expenses. No litigation charges were disclosed in either the 2001 or 2003 income statement, As a result, treating this item as nonrecurring seems appropriate.

The use of the word “settlement” often indicates that cash payments were paid. However, there still may be delays in making the actual cash distributions associated with such settlements. In addition, sometimes the settlement will involve the use of noncash assets, for example, shares of common stock. In such a case there would still be a nonrecurring charge, but it would not be an item of nonrecurring operating cash flow.

In the case of the Techne litigation, settlement did in fact imply that payment was made in 2002. Techne disclosed the payment in its discussion of 2002 results of operations in the MD&A:

In May 2002, the parties agreed to a $17.5 million cash settlement of the dispute. The settlement was paid in June 2002 with cash on hand and the liquidation of approximately $15 million of short-term available-for-sale investments.

The $17.5 million payment made by Techne in a litigation settlement is clearly an item of nonrecurring operating cash flow.

Statement of Cash Flows: Operating Activities Section

The operating activities section of the statement of cash flow does disclose some items of nonrecurring operating cash flow. In addition, it aids the effort to determine whether non-recurring items of revenue, gain, expense, and loss are cash items. The display of changes in working capital accounts within this section is also useful in efforts to assess whether some of the associated cash flows might be nonrecurring.

In many cases, it is actually the absence of an entry for a nonrecurring item in the operating activities section that is informative about cash flow. For example, there was no entry in the operating activities section of the Techne Corp. example immediately above for its $17.5 million litigation charge in 2002. The absence of a cash outflow in 2002 for this charge would be implied if the charge were added back to 2002 net income in arriving at operating cash flow. However, a future cash outflow would not be ruled out. The charge simply may have been accrued in 2002 with payment to take place later. Further investigation would be needed to make this determination.

Union Pacific Corporation & ChevronTexaco, Corp.: Outsized Pension Contributions

Union Pacific Corporation The 2002 operating activities section of Union Pacific’s statement of cash flows lists “cash paid to pension plan” of $225 million, with no contributions listed for 2000 and 2001.¹⁸ Union Pacific’s defined benefit plans had losses on pension assets totaling $401 million in 2000 and 2001, and the plans went from being over- to underfunded status. However, the combination of a $297 million return on plan assets in 2003 and large funding contributions markedly improved the funded status of the plans. Union Pacific reported that it expected to make $50 million of pension contributions in 2004, but that “the 2004 funded pension plan contribution was voluntary.”¹⁹

It seems clear that some portion of the 2002 pension contribution should be considered to be a nonrecurring operating cash flow. In retrospect, if the dramatic losses on pension assets had been anticipated, then some portion of the large catch-up contribution in 2002 would have been made in 2000 and 2001. A recasting of operating cash flows of previous years would deduct some of the later, 2002, contributions. This sort of retroactive adjustment was illustrated in the income tax adjustment in the Avon Products example in Exhibit 6.3.

Such retroactive adjustments have not been part of the adjustments made to earnings for nonrecurring items. However, there has been some discussion of doing so in selected cases, for example, restructuring charges. This effort to smooth out cash flows tends to move away from simply registering cash movements in the period that the inflows or outflows occur. Smoothing, although it may be appropriate in some cases, tends to embrace the accrual concept that is antithetical to the thrust of the cash flow movement. As a general matter, we do not recommend revising the operating cash flow of previous years by placing cash flows into periods in which they did not take place.

ChevronTexaco Corp. ChevronTexaco highlighted its outsized 2003 pension contributions by placing them on a separate line item within the operating activities section of the statement of cash flows. The contributions are presented in Exhibit 6.5.

The information on pension contributions in the exhibit is of course not definitive in establishing that some or all of the pension contributions are nonrecurring in nature. However, disclosed pension contributions should be viewed as potential nonrecurring items of operating cash flow that require further investigation. In this particular case, further investigation leads to information in both the pension note and the Liquidity and Capital Resources section of the MD&A, which suggest that a large portion of the 2003 contribution is nonrecurring.²⁰

Exhibit 6.5 ChevronTexaco Corp., Pension Contributions, Years Ended December 31, 2001, 2002, and 2003 ($ millions)

Source: ChevronTexaco Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 49.

Beyond the pension contributions, the ChevronTexaco cash flow statement includes some other items that should be investigated to determine whether they indicate a nonrecurring operating cash flow. These potential nonrecurring items include what could be outsized dividend distributions from equity affiliates as well as possible nonrecurring cash flows associated with foreign currency gains and losses. A substantial 2002 increase in operating cash flow from a decrease in working capital also merits investigation.

Mississippi Chemical Corp.: Tax Refunds

Mississippi Chemical Corp. disclosed tax refunds received in both 2002 and 2003 on separate line items in the operating activities section of its statement of cash flows.²¹ These tax refunds were derived from provisions of the Job Creation and Workforce Assistance Act of 2002. Although Mississippi Chemical is not explicit on the specific source of this refund, it probably arose from the provision in the act that provided a temporary extension of from two to five years in the carryback period for net operating losses. These cash recoveries are clear items of nonrecurring operating cash flow.

The Beard Co.: Litigation Settlement

The Beard Co. disclosed cash collected from a litigation settlement on a separate line item in the 2003 operating activities section of its statement of cash flows. This cash inflow is very visible because the company presents its operating cash flow in the direct format. The operating activities section is presented in Exhibit 6.6.

Although very visible in the direct format, the settlement gain is not evident at all in the presentation of operating cash flows on an indirect basis. The settlement gain was included in a summary total with other income and expense items in the Beard Co. 2003 income statement. However, the receipt of cash could have been inferred from the fact that the settlement gain of $1,162,000 was not deducted in reconciling net income to net cash used in operating activities. This would have been necessary if the gain was recognized but cash was not yet collected.

Exhibit 6.6 The Beard Co., Operating Activities Section of the Statement of Cash Flows, Years Ended December 31, 2001, 2002, and 2003 ($ thousands)

Source: The Beard Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 41.

It is interesting to note that the Beard Co. makes it clear in the Liquidity and Capital Resources section of its MD&A that the settlement proceeds should not be viewed as recurring. It also points out that there would be a further settlement receipt of $2,826,000 in 2004.

On the other hand, 2003 financial results have benefited, and 2004 results will benefit, from the McElmo Dome settlement in the gross amount of $1,162,000 and $2,826,000, respectively. The settlement is a non-recurring item (emphasis added), so we will not have this benefit in the future except to the extent that McElmo Dome operating results may benefit from improved pricing as a result of the settlement.²²

Changes in Working Capital Accounts

Changes in working capital accounts are disclosed within the operating activities section of the statement of cash flows. Some ebb and flow in working capital is a normal part of growth and decline in the level of business. However, additional attention should be given to changes that are either out of proportion to changes in the level of business activity or opposite in direction from what would be expected. That is, growth and decline in business normally are expected to result in increases and decreases, respectively, in net working capital. As with most initial identifications of potential nonrecurring operating cash flow items, further investigation is required to establish whether the effect of certain changes in working capital on operating cash flow should be considered nonrecurring.

Corn Products International, Inc.: Increases in Accounts Payable and Accrued Liabilities Corn Products International disclosed decreases in net working capital in both 2002 and 2003. Increases in accounts payable were exceeded by increases in accounts receivable and inventories, reducing net working capital and creating a source of operating cash flow. These changes amounted to $65 million in 2002 and $49 million in 2003.²³ Corn Products had relatively flat sales between 2001 and 2002, but a growth in sales of about 15 percent in 2003. It had a typical relationship of current assets and liabilities, with its working capital assets exceeding its working capital liabilities.

The reduction in net working capital in each of these years is not what would be expected with flat or growing sales. Therefore, this information would merit additional investigation to determine whether these operating cash flow benefits should be considered to be nonrecurring. Of the $236 million of cash flow from operations in 2003, which represented an increase of $30 million over 2002, $49 million is attributable to the reduction in working capital. Absent these working capital reductions, cash flow from operations would have declined by $30 million in 2002 and increased by $46 million in 2003.

Corn Products did provide information that is relevant to making the nonrecurring judgment in the Liquidity and Capital Resources section of its MD&A:

We generated $49 million of cash from changes in working capital in 2003, primarily reflecting improved accounts payable processing, as our working capital management program continued to contribute to cash flow growth. ²⁴

It seems unlikely that the company can continue to produce incremental improvements in its working capital positions. Therefore, these cash flow benefits, while real, could be considered a nonrecurring source of operating cash flow.

Other Income and Expense Note

When provided, a note on other income and expenses can be a rich source of information on nonrecurring items, some of which also may prove to be items of nonrecurring operating cash flow. However, these disclosures usually are dominated by items that are either noncash or nonoperating. The disclosures need to be examined very carefully to identify potential nonrecurring operating cash flow items.

C. R. Bard, Inc.: Various Nonrecurring Items

C. R. Bard, Inc. provides a detailed other income and expense note that is presented in Exhibit 6.7.

The C.R. Bard note includes four potential nonrecurring operating cash flow items:

1. Foreign exchange gains and losses

2. Legal and patent settlements

3. Restructuring charges

4. Merger termination costs

The foreign exchange gains and losses would not be considered a nonrecurring item in this case because they are a key feature of Bard’s international operations, are very small, and are a consistent component of other income and expense for at least back to 1998. If in the future a large cash foreign currency gain or loss were to occur, then treating some of the cash flow as nonrecurring might be in order.

The timing and amount of cash flows associated with the remaining items cannot be determined from their disclosure in the other income and expense note alone. Rather, other disclosures will need to be examined. Again, this process is illustrated in detail in the next section of this chapter. However, to provide some preliminary insight into cash flow status, the C. R. Bard statement of cash flows was examined. A “Provision for 2003 legal verdict” of $58.0 million was added back to net income in reconciling net income to cash flow from operating activities. This charge was the major component of the $54.5 million “Legal and patent settlements, net” in Exhibit 6.7. The addition of this charge to net income reveals that there was no cash outflow in 2003 for the dominant component of the legal and patent settlement charge, net. In addition, the entire 2002 restructuring charge of $33.7 million was added back to net income.

Exhibit 6.7 C. R. Bard, Inc., Other Income and Expense Note, Years Ended December 31, 2001, 2002, and 2003 ($ thousands)

Source: C. R. Bard, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. II-55.

Although arguably nonrecurring items in terms of earnings, neither the $33.7 million restructuring charge in 2002 nor the legal verdict charge of $58.0 million in 2003 represents nonrecurring operating cash flow items in the years in which they were accrued. However, if paid in subsequent periods, each of these items then could be considered items of nonrecurring operating cash flow.

The last prospective nonrecurring operating cash flow item from Exhibit 6.7 is the “Merger termination costs” item. The charge of $6.2 million in 2002 appears to have been paid in 2002 because it was not added back to net income in the operating section of the statement of cash flows. Therefore, it is a nonrecurring operating cash outflow .²⁵

Inventory Note

Although the inventory note is often a source of information on nonrecurring charges and credits, these items seldom involve a current or prospective cash inflow or outflow. The most common nonrecurring item is the noncash write-down of inventory. However, disclosures of increases and decreases in earnings as a result of last in, first out (LIFO) liquidations are also quite common in inventory notes. The earnings effects of the LIFO liquidations are the result of cost-of-sales differences that result from reducing physical inventory levels and including older as opposed to current replacement costs in cost of sales. In almost all cases older costs are lower than current replacement costs and the LIFO liquidations increase pretax earnings.

There are also two potential nonrecurring operating cash flow effects. First, there is a nonrecurring cash benefit associated with the inventory reduction if there is no plan to restore the inventory levels. However, offsetting this to some extent are the increased cash tax payments or tax recoveries for firms in a loss position.

Union Carbide: Effect of LIFO Liquidations

This disclosure of LIFO liquidations is from the inventory note of Union Carbide Corp.:

A reduction of certain inventories resulted in liquidation of some quantities of LIFO inventory, which increased pretax income by $2 million in 2003, and reduced pretax loss by $31 million in 2002 and $53 million in 2001 .²⁶

Union Carbide’s results are improved as income is increased or losses reduced by the introduction of older and lower costs into the cost of sales calculation while the products are sold at current price levels. The gains and losses associated with LIFO liquidations typically are considered to be nonrecurring in terms of earnings analysis.

Union Carbide’s disclosures reveal that, despite its pretax loss position in 2001 and 2002, it did pay income taxes of $49 million in 2002 and $17 million in 2003, while receiving tax recoveries of $32 million in 2001.²⁷ As a result, the LIFO liquidations would have the effect of reducing the tax recovery in 2001, by reducing the loss carryback and associated recovery of previous tax payments and increasing tax payments in both 2002 and 2003. If the LIFO liquidation gains are considered to be nonrecurring, then the associated cash tax effects should be as well.

Income Tax Note

Income tax notes often include disclosures of additional tax payments or receipts that are the result of settling tax disputes with governments. This topic was discussed extensively in Chapter 5. In addition, the tax benefits of carrying net operating losses (NOLs) either back, providing refunds, or forward, providing reductions in future tax payments, sometimes are disclosed as well. These tax items are generally viewed as nonrecurring in earnings analysis and also would be considered to be nonrecurring items of operating cash flow if there are associated cash inflows or outflows.

Albemarle Corp.: Cash Tax Settlement

Albemarle Corp. disclosed the receipt of cash from a tax settlement. Interestingly, this nonrecurring operating cash inflow was divided between taxes and other income. The disclosure of the item of nonrecurring operating cash inflow was in a footnote to Albemarle’s tax note.

On April 25, 2002, the Company received a favorable tax settlement of $4,509,000, which included interest of $2,017,000 (reflected in other income, net), from the Internal Revenue Service on its claims for adjustments of export benefits for the years 1994 and 1995.²⁸

Albemarle also disclosed receipt of an additional tax refund of $6,199,000 in 2003.²⁹ In addition to disclosure in the text of its tax footnote, the Company also highlighted the presence of the two tax benefits in the reconciliation of the federal statutory to the effective income tax rates. This schedule is provided in Exhibit 6.8.

Other Notes

The footnotes just discussed are important, but they represent only a small portion of the total footnotes found in a typical annual report. Almost any footnote has the potential either to reveal a nonrecurring item or to help to establish its cash flow status. Because time is never unlimited or without cost, a cost-effective search for nonrecurring items of operating cash flow should permit the examination of only a subset of footnotes and other disclosures. That is, a less than exhaustive search should make it possible to identify most material nonrecurring items of operating cash flow. Some guidance in making these choices is provided at the end of this chapter. The additional notes discussed next also have a reasonable likelihood of revealing nonrecurring items and their associated cash flow status.

The Coca-Cola Co.: Restructurings

Note disclosures of restructuring charges are a very common source of information on nonrecurring items of operating cash flow. These disclosures are very useful because of timing differences between when such charges are recorded in the income statement and when they are actually paid. In addition, a portion of these charges typically involves asset write-downs and impairment charges that do not result in either current or future cash outflows. Although “restructuring” is the generic label given to these charges, a variety of different labels also are used. Most involve words beginning with the letter “r,” such as: rationalizing, reorganizing, redeploying, reengineering, and rightsizing.

Exhibit 6.8 Albemarle Corp., Tax Reconciliation Schedule, Years Ended December 31, 2001, 2002, and 2003 ($ thousands, except for percentages)

Source: Albermarle Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, pp. 42-43.

Coca-Cola deviated from the “r” norm by using an “s” word to describe its restructuring efforts. Its restructuring disclosure is provided in Exhibit 6.9. The schedule reveals that of the total streamlining costs of $561 million incurred in 2003, only $219 million involved a cash outflow. Moreover, the asset impairment component will never require a cash payment. Most of the remaining accrued streamlining balance will require a cash payment in subsequent years.

In addition to the streamlining note, the streamlining costs in Exhibit 6.9 were also disclosed in MD&A.³⁰

Restructuring payments usually will be considered to be nonrecurring operating cash flows. However, for some firms that appear to be in a constant state of restructuring, the nonrecurring classification in general might not apply. However, occasional outsized restructuring payments still might be considered to be nonrecurring operating cash outflows. The influence of the 2003 streamlining payments was referenced in the Liquidity and Capital Resources section of MD&A: “Streamlining costs in 2003 accounted for significant cash payments.”³¹ Although classified as other operating charges, the streamlining costs were disclosed as separate line items in both the Coca-Cola income statement and statement of cash flows.³²

Exhibit 6.9 The Coca-Cola. Co., Streamlining Note, Year Ended December 31, 2003 ($ millions)

Source: The Coca-Cola Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 94.

AT&T Corp.: Supplementary Cash Flow Information

Firms provide selected supplementary cash flow information either as part of the statement of cash flows or in a separate note. The key information in terms of nonrecurring items of operating cash flow is the amount of income taxes paid or recovered. AT&T Corp. provided this supplementary information in a separate note to its financial statements. Exhibit 6.10 provides the AT&T tax payments and receipts for years ended December 31, 2001, 2002, and 2003.

AT&T highlighted the significance of the disclosures about its tax receipts and payments by discussing their contribution to its operating cash flow: “Favorably impacting cash flow in 2002 were income tax receipts of $0.8 billion compared with income tax payments of $1.4 billion in 2001.”³³ Tax payments are as recurring as the taxable earnings that drive them. However, tax receipts, or refunds, are inherently nonrecurring because they are a product of losses that are carried back, usually for two years, to offset previous taxable income and recover the earlier tax payments. The potential tax recoveries are limited to the amount of the current loss and the profits in the carryback period. Therefore, the contribution of these tax refunds to operating cash flow is not sustainable.

Exhibit 6.10 AT&T Corp., Disclosure of Tax Receipts and Payments, Year Ended December 31, 2001, 2002, and 2003 ($ millions)

Source: AT&T Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 54.

Management’s Discussion and Analysis

The most fruitful sections of the MD&A in locating nonrecurring items of operating cash flow are those that focus on explaining changes in earnings for successive years, for example, 2002 to 2003 and 2003 to 2004, as well as the section on Liquidity and Capital Resources.

Earnings Comparisons

It is standard for MD&A to include earnings comparisons for the last three years. For example, a 2005 10-K report will include a discussion of the reasons for changes in earnings for 2003 to 2004 and 2004 to 2005. It is also typical for firms to disclose nonrecurring items of revenue, gain, expense, and loss in explaining the reasons for these earnings changes. However, it is important to note that the focus of MD&A is typically on earnings information. Although occasionally information about cash flow may be disclosed, this section of the MD&A is not cash flow oriented. Accordingly, usually additional analysis is required to establish if and when an identified nonrecurring item of earnings is associated with an operating cash flow.

Timco Aviation Services, Inc.: Collection of Fully Reserved Account Receivable Timco Aviation Services disclosed a nonrecurring operating cash inflow from the collection of an account receivable. As it noted: “We resolved a long standing customer dispute and collected $925 thousand of accounts receivable that was previously fully reserved.”³⁴ This disclosure simultaneously reveals this nonrecurring item of operating income as well as the fact that an associated cash inflow took place in the same reporting period.

Liquidity and Capital Resources

The Liquidity and Capital Resources section of the MD&A is cash flow oriented, especially the Liquidity section. Of special value is the discussion of changes in cash flows from operating activities for adjacent years. Management often discloses nonrecurring items of operating cash flow as a part of this process of explaining changes in operating cash flow.

Krispy Kreme Doughnuts, Inc.: Stock Option Tax Benefits Krispy Kreme disclosed cash benefits from the exercise by employees of their stock options in its Liquidity and Capital Resources section. The recent cash benefit for fiscal 2004 of $42.8 million was 210 percent higher than the fiscal 2003 benefit of $13.8 million.³⁵ Krispy Kreme’s management signaled the potentially nonrecurring character of this benefit in this statement: “The Company’s operating cash flows may continue to be favorably impacted by similar tax benefits in the future; however, the exercise of stock options is outside of the Company’s control.”³⁶

The Krispy Kreme disclosures confirm a current reduction in cash tax payments.³⁷ That is, the option tax benefits have been realized. However, realization in this case takes the form of a reduction in tax payments and not an inflow of cash. The Chapter 5 discussion on the tax benefits of stock options makes it clear that the recognition of these benefits and the realization of the associated cash benefit may not occur in the same period.

The fiscal 2004 realized tax benefits from stock options amounted to 45 percent of Krispy Kreme’s cash flow from operating activities. A decline in the value of the Krispy Kreme common stock could significantly reduce the option tax benefits and with it the company’s operating cash flow. The Krispy Kreme tax benefits from stock options are clearly a nonrecurring source of operating cash flow.³⁸

Oxford Industries, Inc.: Inventory Reduction In a comparison of operating cash flow from 2001 to 2002, the Liquidity and Capital Resources section of Oxford Industries highlights a large inventory reduction: “Inventory declined $62,829,000 or 43% from $147,370,000 in 2001 to $84,541,000 in 2002 due to better asset management.”³⁹ Inventory reductions of this magnitude due to “better asset management” are unlikely to be sustained. This lack of sustainability of inventory reductions is affirmed by the subsequent inventory increase of $20 million in 2003.

Kroger Co.: Accounts Payable, Tax Benefits, and Pension Plan Contributions Kroger identified fluctuations in accounts payable balances as contributing to increases in 2002 operating cash flows and decreases in 2003. In the case of 2002, Kroger states: “In 2002, our accounts payable balances increased substantially due to an enterprise system conversion that enabled our western divisions to improve their accounts payable position.”⁴⁰ The 2003 decrease in accounts payable was due to another change related to the transfer of deposits to concentration accounts.

Kroger also highlights the transient nature of tax savings resulting from post-September 11 tax legislation:

The amount of cash paid for income taxes in 2003 and 2002 was lower that the amount paid in 2001 due, in part, to a tax law benefit that will continue through 2004. Under current law, the bonus depreciation provision will expire in December 2004 and we expect the cash benefit will begin to reverse in 2005 .⁴¹

Kroger also disclosed these tax benefits of $22 million in 2001, $106 million in 2002, and $130 million in its income tax note.

Finally, Kroger also made reference, as part of an explanation of changes in year-to-year operating cash flow, to a pension contribution: “Our 2003 operating cash flow results also reflect a $100 million cash contribution to our company-sponsored pension plan.”⁴² The pension note disclosed a $4 million pension contribution in 2002 and $104 million in 2003. Kroger also disclosed planned contributions of $34 million on September 15, 2004, plus an additional contribution on the same date of $149 million. This language implies that the $34 million is required and the $149 million is probably more discretionary., Also in the pension note, Kroger reports that these 2004 contributions “will reduce minimum required contributions in future years.”⁴³

The characteristic shared by each of the items disclosed and discussed by Kroger is their nonrecurring or irregular contribution to operating cash flows. The Kroger Liquidity and Capital Resources disclosures are an especially rich example of the disclosure of information that is helpful in the effort to identify items of nonrecurring operating cash flow.

The discussion in this section on locating potential nonrecurring items of operating cash flow is not intended to be exhaustive. For example, only a subset of notes to the financial statements that might yield nonoperating or nonrecurring operating cash flow items is reviewed. However, we believe that these disclosures are those most likely to be fruitful in locating both nonoperating and nonrecurring items of operating cash flow. Once the items are located, further analysis usually is required to determine if and when a nonoperating or nonrecurring item will produce a source or use of cash flow. This is the focus of the next section.

CASH FLOW TRACKING

In a limited number of cases the initial identification of a nonrecurring item and the determination of its cash flow status take place simultaneously. For example, the 2003 Pilgrims Pride Corp. income statement listed a line item for $45 million in nonrecurring recoveries. This early disclosure in the search procedure, as well as the use of the term “recoveries,” made it clear that the items in this income statement entry were cash flow backed.⁴⁴ These nonrecurring items consisted of payments received from the U.S. government related to an avian influenza outbreak and litigation proceeds.⁴⁵ However, in most cases a number of different steps and the examination of several disclosures are necessary in order to establish that a nonrecurring cash flow has occurred. We refer to this process as cash flow tracking and illustrate it with a series of case examples.

Bristol-Myers Squibb Co. Litigation Settlement Charge

Cash paid or received related to litigation is one of the more common nonrecurring operating cash flow items.⁴⁶ The Bristol-Myers Squibb Co. income statement for 2002 includes a litigation settlement charge of $659 million .⁴⁷ The charge or expense is recorded on the basis of accrual accounting principles, and it is not possible to tell from the income statement entry alone whether cash has been paid or not. The best way to establish that cash was not paid is to review the operating activities section of the 2002 statement of cash flows and look for an addition of the litigation charge back to net income. In fact, the entire charge was added back to net income in arriving at cash from operating activities, indicating that cash was not paid in 2002.

If the litigation charge did not appear in the operating section of the Bristol-Myers cash flow statement, then a review of the income tax note is a useful alternative source of information about the item’s cash flow status. If Bristol-Myers accrues a litigation charge on its books that it has not yet paid, then a temporary difference is created. That is, an expense is recorded on the income statement that will become a deduction in the tax return only when cash is paid to settle the litigation. A deferred tax asset would be recorded to reflect the future tax savings associated with the litigation charge.

The relevant portion of the Bristol-Myers tax note—the schedule of deferred tax assets and liabilities—in fact revealed a deferred tax asset for the legal settlement. This information is presented in Exhibit 6.11.

The $207 million deferred tax asset in the exhibit represents the future tax savings that will be realized when the litigation settlement of $659 million is paid and an expense deduction then is taken in the Bristol-Myers income tax return. Again, the presence of this deferred tax asset indicates that the deduction for the legal settlement was taken in the income statement but not yet in the tax return.

Exhibit 6.11 Bristol-Myers Squibb Co., Deferred Tax Asset and Legal Settlement, Years Ended December 31, 2001, and 2002 ($ millions)

Source: Bristol-Myers Squibb Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 71.

	2001	2002
Legal settlement	—	$207

The tax rate used in recording the Bristol-Myers deferred tax asset is about 31 percent. This is determined by dividing the $207 million deferred tax asset by the associated $659 million legal settlement ($207 million / $659 million = 31 percent). This somewhat reduced rate is not surprising because the Bristol-Myers effective income tax rates from 2000 to 2002 were 25, 3, and 16 percent, respectively. The primary sources of these reduced effective rates were operations in locations with lower tax rates, including Ireland, Puerto Rico, and Switzerland.⁴⁸

Although it was not paid in 2002, the Bristol-Myers 2003 disclosures reveal the actual payment of the 2002 litigation charge. The 2003 Bristol-Myers income statement shows the accrual of new net litigation charges of $199 million. Net charges were only $77 million in 2001, reinforcing the view that much of the 2002 charge, and associated 2003 cash payment, should be viewed as nonrecurring. The 2003 Bristol-Myers statement of cash flows shows litigation settlement payments, net of receipts, of $604 million. ⁴⁹ Although the receipts are not disclosed, it is clear that most if not all of the 2002 litigation charges were paid in 2003.

In the absence of disclosure of the payment in the 2003 operating activities section of the Bristol-Myers statement of cash flows, the behavior during 2003 of the litigation-related deferred tax asset was consistent with the payment having been made. That is, the $207 million deferred tax asset in Exhibit 6.11 was no longer present in 2003. ⁵⁰ The unrealized tax savings of $207 million associated with the legal settlement charge of $659 were realized. The legal settlement was paid and a deduction was taken in the Bristol-Myers tax return. This deduction of $659 million shielded a like amount of income from taxation and saved $207 million in taxes.

Cox Communications, Inc.: Pension Contributions

The Pilgims Pride Corp. and Bristol-Myers Squibb Co. nonrecurring items of operating cash flow were located early in the standard search sequence discussed earlier in this chapter. Moreover, the cash flow status of these companies was quickly established. However, the search sequence that is quite effective in locating nonrecurring income items needs an important modification when the ultimate objective is to locate nonoperating and nonrecurring items of operating cash flow. The Liquidity and Capital Resources section of MD&A should be reviewed early in the search process.

In the Cox Communications, Inc., case, an examination of the income statement, operating activities section of the statement of cash flows, other income and expense note, or income tax note did not suggest the presence of a nonrecurring pension cash outflow. However, a review of the Liquidity and Capital Resources section of the Cox Communications MD&A and the pension note disclosed an outsized pension contribution in 2003. The Liquidity and Capital Resources section included this statement: “Cox contributed its total planned 2003 plan year contributions for the funded pension plans during 2003. Due to this accelerated contribution, Cox does not anticipate additional contributions during 2004 for the funded pension plans.”⁵¹

The outsized pension contribution also was revealed by the disclosure of changes in plan assets of the Cox Communications defined benefit pension plans presented in Exhibit 6.12.

The nonrecurring operating cash flow in the Cox Communications case would be the difference between the actual contribution in 2003 and a more typical contribution level. This excess of the actual contribution over a more typical level would be added back to reported cash flow from operating activities. The adjustment typically would be on an after-tax basis.

Metro-Goldwyn-Mayer, Inc.: Due Diligence Expenses

Metro-Goldwyn-Mayer (MGM) disclosed a charge in its income statement for 2003 that was titled “due diligence expenses.”⁵² The charge was added back to its net loss in arriving at cash flows from operating activities.⁵³ This disclosure normally would indicate that the charge did not involve a cash payment in 2003. If so, then as was the case with the litigation charge of Bristol-Myers Squibb, a deferred tax asset should appear in the income tax note. That is, an expense was recorded on the income statement that was unlikely to have been deductible in the tax return because it was not paid in cash. However, a review of the MGM schedule of deferred tax assets and liabilities revealed no such deferred tax asset.”⁵⁴

Exhibit 6.12 Cox Communications, Inc., Selected Pension Disclosures, Years Ending December 31, 2002, and 2003 ($ thousands)

Source: Cox Communications, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 81.

		2002	2003
Change in Plan Assets
	Fair value of plan assets at beginning of year	$158,101	$176,571
	Actual return (loss) on plan assets	(7,323)	45,274
	Employer contributions	28,448	55,915
	Benefits paid	(2,655)	(3,055)
	Fair value of plan assets at end of year	$176,571	$274,705

A return to the MGM statement of cash flows revealed that the “due diligence expenses” added back to the MGM net loss were listed as a cash outflow in the investing activities section of the 2003 statement of cash flows. So there was a nonrecurring expense and a cash outflow linked to that expense. However, the cash outflow was classified as an investing item and is not a nonrecurring item of operating cash flow. As demonstrated here, in cash flow tracking it is important to look beyond just the operating activities section of the statement of cash flows.

EarthLink, Inc.: Merger-Related Charges

The 2000 income statement of EarthLink revealed “merger related charges” of $33,967,000. The operating activities section of the statement of cash flows was examined to determine if there was any associated cash flow and, if so, its classification within the statement of cash flows. There was no add back to EarthLink’s net loss for the year in the operating activities section. Therefore, the implication was that there were cash payments for the charges. That is, the charges reduced earnings and also were paid in cash during the same period. Both earnings and operating cash flows were reduced.

Further tracking of the charges beyond the income statement and statement of cash flows, to include a review of notes to the financial statements, provides additional insight. A note on Merger and Restructuring and Facility Exit Costs revealed that $32,891,000 of the $33,967,000 of charges was paid during the year 2000. The difference between these two amounts constitutes a noncash charge. Although not material in amount, nonrecurring operating cash payments would have been overstated by $1,076,000 ($33,967,000 - $32,891,000) in the absence of moving beyond the statement of cash flows to the footnote disclosure.⁵⁵

Newell Rubbermaid, Inc.: Interest Rate Swap Termination

The Liquidity and Capital Resources section of the MD&A should be reviewed early in the search process for nonrecurring items of operating cash flow. In the Newell Rubbermaid, Inc., income statement, the operating section of the statement of cash flows, other income and expense note, inventory note, and tax note yielded nothing about the operating cash inflow from an interest rate swap termination that eventually was located. However, this item was disclosed both as an additional note to the financial statements and in the Liquidity and Capital Resources section of the Newell Rubbermaid MD&A. The relevant portion of the note follows:

Gains and losses resulting from the early termination of interest rate swaps are deferred as an increase or decrease to the carrying value of the related debt and amortized as an adjustment to the yield of the related debt instrument over the remaining period originally covered by the swap. The cash received relating to the termination of interest rate swaps is included in “other” as an operating activity in the Consolidated Statement of Cash Flows.⁵⁶

In this case of cash tracking, the nonrecurring item is located simultaneously with the revelation that the cash flow from the swap termination was classified in operating cash inflow. However, this disclosure did not reveal the amount of the cash inflow. The referenced line item, “other,” in the operating activities section of the statement of cash flows might include more than just the swap termination cash inflow. The disclosure in the Liquidity and Capital Resources section provided a detailed listing of sources and uses of liquidity and capital resources. Included was this paragraph:

Cash provided from operating activities for the year ended December 31, 2003 was $773.2 million compared to $868.9 million for the comparable period of 2002. The decrease in cash provided from operating activities was due to a decrease in earnings before non-cash charges of $29.0 million . . . and a reduction in the year-over-year improvement in working capital and other assets in 2003 versus 2002, which used an additional $74.2 million, partially offset by an increase in deferred gains relating to the early termination of certain interest rate swap arrangements. The deferred gain from these swap agreements was $28.3 million in 2003 compared to $20.8 million in 2002 and was included in other in the Consolidated Statement of Cash Flows.⁵⁷

Notice that the cash received of $20.8 million in 2002 and $28.3 million in 2003 from the swap terminations is disclosed in the excerpt from the Liquidity and Capital Resources section. We would consider these swap termination cash flows to be nonrecurring in view of the substantial uncertainty surrounding their likely sustainability.

Summary of Cash Flow Tracking

There is inherent potential for overlap of the processes of locating potential items of non-recurring operating cash flow and determining their cash flow status. In some cases, the steps merge into one. The initial identification of a potential nonrecurring component of operating flow usually must be followed up with further analysis to determine its cash flow status. We characterize this process as cash flow tracking.

In earnings analysis, the search sequence for nonrecurring items of revenue, gain, expense, and loss normally starts with the income statement and then moves to the operating activities section of the statement of cash flows, the other income and expense note, the inventory note, the income tax notes, other notes, and MD&A. This same general sequence is recommended in searching for potential nonrecurring operating cash flow items. However, our experience suggests that making the MD&A, and in particular the section on Liquidity and Capital Resources, step 1 in the process can accelerate and make more efficient the location of many nonrecurring items of operating cash flow.

Reviewing the Liquidity and Capital Resources section as step 1 in the overall process of locating nonrecurring items of operating cash flow will, in some cases, collapse the identification and determination of cash flow status. However, when MD&A is less forthcoming, determination of the cash flow status of various items will require the cash flow tracking method illustrated here. Cash flow tracking entails the steps presented in Exhibit 6.13.

SUMMARY

The nine key points raised in this chapter include:

1. There is a long tradition of adjusting reported net income for the effects of nonrecurring items of revenue, gain, expense, and loss. The logic is that these adjusted results provide more reliable indicators of underlying operating performance and that they also are a sounder basis from which to develop forecasts of future earnings. We believe that the same position is applicable to operating cash flow.

Exhibit 6.13 Summary of the Cash Flow Tracking Process

2. Nonrecurring items of operating cash flow share one or more of the following characteristics:

a. Irregular in occurrence

b. Irregular in amount

c. Not associated with the core operating activities of the firm

3. The identification of nonrecurring items of operating cash flow involves the exercise of considerable judgment. At times it is difficult simply to render a yes/no decision on a nonrecurring classification. Gradations of nonrecurring cash flow are introduced in the next chapter as an approach to dealing with this important judgmental component of identifying operating cash flows.

4. There is a great deal of variety in items that can reasonably be considered nonrecurring items of operating cash flow. Most of these items have an income statement counterpart. Two common examples are litigation charges and restructuring charges.

5. A small subset of nonrecurring operating cash flow items has no income statement counterpart. Outsized changes in working capital and outsized pension contributions are two examples.

6. The initial search for nonrecurring items of operating cash flow follows in broad outline the same process employed to locate nonrecurring items of revenue, gain, expense, and loss. A key addition to the search process is an early careful review of the Liquidity and Capital Resources section of MD&A. This is a very rich source of information on nonrecurring items of operating cash flow. Moreover, this section typically discloses nonrecurring items and their cash flow status simultaneously.

7. Once potential items of nonrecurring operating cash flow are identified, often a second step is necessary to establish if and when cash inflows and outflows occur. We refer to this process as cash flow tracking.

8. The operating activities section of the statement of cash flows, the Liquidity and Capital Resources section of the MDA, and the income tax note are some of the most important tools used in cash flow tracking.

9. It is rare for firms to revise systematically and comprehensively their reported operating cash flow by removing nonrecurring items. However, it is becoming more common for firms to make limited adjustments designed to remove the effects of nonrecurring items of operating cash flow.

NOTES

1 Comcast Corp., annual report, December 31, 2003, p. 17.

2 Cox Communications, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 83.

3 See E. Comiskey and C. Mulford, Guide to Financial Reporting and Analysis (Hoboken, NJ: John Wiley & Sons, 2000), chapter 3, for an extensive presentation on the revision of earnings that removes nonrecurring items of revenue, gain, expense, and loss from reported earnings.

4 While made about earnings, one could readily substitute “operating cash flow” for “earnings” into this statement from a study made by a committee of the American Institute of Certified Public Accountants: “Users want information about the portion of a company’s reported earnings that is stable or recurring and that provides a basis for estimating sustainable earnings.” American Institute of Certified Public Accountants, Improving Business Reporting—A Customer Focus (New York: AICPA, 1993), p. 4.

5 Cox Communications, Inc., Form 10-K annual report to the SEC.

6 Kellogg Company, annual report, December 31, 2003, p. 25.

7 Kennametal, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 38.

8 Avon Products, Inc., annual report, December 31, 2002, p. 34.

9 The treatment of sales of accounts receivable is discussed in Chapter 4.

10 Chapter 10 is devoted to free cash flow.

11 A report by the Center for Financial Research and Analysis, “The Pro-forma Presentation of Operating Cash Flow,” April 23, 2004, is quite critical of Delphi’s restated operating cash flow. We share the report’s concern about the failure to make tax adjustments as well as treating the entire amount of the pension contributions as nonrecurring.

12 C. Mulford and E. Comiskey, Financial Warnings (New York: John Wiley & Sons, 1996), chapters 5 and 6, and Comiskey and Mulford, Guide to Financial Reporting and Analysis, chapters 2 and 3.

13 ResMed, Inc., Form 10-K annual report to the Securities and Exchange Commission, June 30, 2003, p. F-3.

14 Timco Aviation Services, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. F-5.

15 Continental Airlines, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 22.

16 Ibid., Item 7, Liquidity and Capital Resources of MD&A.

17 Ibid., p. 29.

18 Union Pacific Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 39.

19 Ibid., p. 56.

20 ChevronTexaco Corp, Form 10-K annual report to the Securities and Exchange Commission, pp. 35 and 69.

21 Mississippi Chemical Corp., Form 10-K annual report to the Securities and Exchange Commission, June 30, 2003, p. 44.

22 The Beard Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, Item 7, Liquidity and Capital Resources.

23 Corn Products International, Inc., annual report, December 31, 2003, p. 37.

24 Corn Products International, Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, Item 7.

25 The $0.4 million benefit in Exhibit 6.7 related to the merger and termination costs probably represents either the reversal of a previously accrued liability or the recovery of previous costs. There would be no cash inflow if a liability balance were simply reversed. However, there would be a small nonrecurring operating cash inflow if a refund of costs previously paid was received.

26 Union Carbide Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 33.

27 Ibid., p. 37.

28 Albemarle Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 35.

29 Ibid., pp. 42-43.

30 The Coca-Cola Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, pp. 37-38.

31 Ibid., p. 42.

32 Ibid., pp. 51 and 54.

33 AT&T Corp., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 54.

34 Timco Aviation Services, Inc., Form 10-K annual report to the Securities and Exchange Commission, p. 21.

35 Krispy Kreme Doughnuts, Inc., Form 10-K annual report to the Securities and Exchange Commission, February 1, 2004, pp. 32-33.

36 Ibid., p. 32.

37 There is no actual cash flow in this situation. Rather, a deductible expense is recorded for income tax purposes. This reduces taxable income and with it current cash tax payments.

38 Krispy Kreme Doughnuts, Inc., has seen its share price decline in recent months (written in October 2004). The decline is driven in part by the embrace of the low carb diet. The first quarter of fiscal 2005 for Krispy Kreme showed $1.6 million of option tax benefits versus $6.0 million of the first quarter of fiscal 2004. Krispy Kreme Doughnuts, Inc., Form 10-Q quarterly report to the Securities and Exchange Commission, quarter ended May 2, 2004, p. 6.

39 Oxford Industies, Inc., Form 10-K report to the Securities and Exchange Commission, May 31, 2002, p. 21.

40 Kroger Co., Form 10-K annual report to the Securities and Exchange Commission, January 31, 2004, Item 7, Liquidity and Capital Resources section of MD&A.

41 Ibid.

42 Ibid.

43 Kroger Co. Form 10-K annual report to the Securities and Exchange Commission, January 31, 2004, Item 8, Note 18 on Benefit Plans.

44 Pilgrims Pride Corp., Form 10-K annual report to the Securities and Exchange Commission, September 27, 2003, p. 79.

45 The receipt of funds from the U.S. government related to the avian influenza outbreak reflects the fact that Pilgrims Pride Corp. is in the poultry business.

46 For some firms litigation charges have become rather common. In such cases, it is more likely that the key will be to focus on atypical levels of litigation cash flows. The nonrecurring cash flow would be the deviation from what might be considered the typical level of litigation cash flow activity.

47 Bristol-Myers Squibb Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2002, p. 48.

48 Ibid., p. 70.

49 Bristol-Myers Squibb Co., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 61.

50 Ibid., p. 82.

51 Cox Communications, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31, 2003, p. 45.

52 Metro-Goldwyn-Mayer, Inc., Form 10-K annual report to the Securities and Exchange Commission, December 31 2003, p. 61.

53 Ibid.

54 Ibid., pp. 79-81. A deferred tax asset might have been buried in a large balance labeled “Net miscellaneous tax assets.”

55 Ibid., p. 80.

56 Newell Rubbermaid, Inc., annual report, December 31, 2003, p. A-29.

57 Ibid., p. A-10.

CHARACTERISTICS OF NONRECURRING ITEMS OF OPERATING CASH FLOW

EXAMPLES OF NONRECURRING CASH SOURCES AND USES