U.S. GAAP requires that three special items be displayed on an after-tax basis in the income statement, they are: (1) discontinued operations, (2) extraordinary items, and (3) the cumulative effect of changes in accounting principle. All three offer unique cash flow reporting issues that are not addressed by SFAS No. 95. If presented in an income statement format, items of other comprehensive income, for example, unrealized gains and losses on available for sale securities and foreign currency translation adjustments, are also displayed on a net of tax basis. Items of other comprehensive income typically are reported in shareholder’s equity and seldom involve cash flows and so on. In this post I provide light overview of reporting practices for these three special items on income statement [discontinued operations, extraordinary items, and the cumulative effect of changes in accounting principle] provides insight into their typical treatment in the statement of cash flows. Enjoy!
Treatment as a discontinued operation requires that a unit qualify as a component of an entity. A component of an entity “comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity”. Discontinued operations include operating results and gains or losses on the disposition of assets of the discontinued operations. Although not required, many firms separate the operating cash flow of continuing operations from that of discontinued operations.
Extraordinary items are defined as items of revenue, gain, expense, and loss that are “distinguished by their unusual nature and by the infrequency of their occurrence”. The joint requirements of unusual and infrequent have proved to be an increasingly difficult hurdle to overcome. As a result, extraordinary items have become increasingly rare in recent years. Until very recently, almost all extraordinary items were the result of debt repayments that gave rise to either gains or losses. The most recent AICPA survey data show a total of 78 extraordinary items out of 600 companies in the annual survey. Of these, 70 were the result of debt extinguishments. However, some firms continue to classify gains and losses on debt extinguishments as extraordinary even though it is now no longer required. This classification would be based on the company’s judgment that the gains and losses are both unusual and infrequent in their occurrence.
In computing operating cash flow on an early debt retirement, a gain is deducted from net income while a loss is added back. Any cash payment made to discharge the debt is listed as a cash outflow in the financing activities section of the statement of cash flows.
The classification of any cash flow associated with other extraordinary items will depend on the specific character of the gains and losses. For example, consider a gain from insurance proceeds received due to damage sustained to a corporate headquarters building by an earthquake. Assume that the gain is classified as extraordinary. The gain would be deducted from net income in computing operating cash flow, and the cash received would be reported as investing cash inflow.
Cumulative Effects of Changes in Accounting Principles
Most current accounting changes occur when firms adopt a new accounting standard issued by the FASB. Less frequently, changes in accounting principles result from firms making discretionary changes from one existing acceptable accounting principle to another. You may include a switch from the completed contract method of accounting for long-term contracts to the percentage-of-completion method or from the use of accelerated to straight-line depreciation.
Most accounting changes are implemented using the cumulative effect method. This requires that a gain or loss be recorded in the income statement in the year of the change for the amount by which earnings in prior years would have been affected if the new method had been in use. The cumulative effect always is included in the income statement on an after-tax basis.
Unlike changes in computing taxable income, the effects on net income of changes in accounting principles do not affect cash flow. Accordingly, an accounting change that reduces net income is simply added back to net income, and a change that increases net income is subtracted in computing cash flow from operating activities.