Under the indirect method, income is adjusted for noncash expenses such as depreciation, depletion, and amortization of operational assets. Income is also adjusted for changes in selected components of current assets and current liabilities that are related to operating activities. For example, companies adjust income for cash inflows or outflows related to changes in accounts receivable, inventory, prepaid items, accounts payable and accrued liabilities.

Income is also adjusted for other transactions that affect income but do not affect cash flows from operating activities. For example, a loss on sale of equipment is added to income because the loss reduces income but does not result in an outflow of cash. Several unique transactions that require adjustments to income were identified in the review of reports. The items may be infrequently encountered but CPAs should be alert to identify circumstances requiring adjustment of income to correctly report cash flows from operating activities.

Where to Begin

A discussion of cash flows should probably begin with the selection of the income statement item that starts the computation of cash flows from operating activities. Some firms begin with "net income" while others select "income from continuing operations," or "primary operations." Companies that select net income as their starting figure must make adjustments for all items reported after income from continuing operations on the statement of income. Examples are discontinued operations, extraordinary gains (losses), and the cumulative effect of changes in accounting principles.

Discontinued Operations On the statement of cash flows, a loss from discontinued operations is added to the net income figure in the computation of cash flows from operating activities. Pitney-Bowes Company, on each consolidated statement of cash flows prepared for 1987, 1988, and 1989, began its cash flows from operating activities with net income. The company added the loss from discontinued operations to arrive at cash flows from operations. If an adjustment is required, most companies normally handle it like the Pitney-Bowes Company did. However, there are other methods to report the results of discontinued operations.

Ryder System reported discontinued operations in a unique manner. After reporting net cash flows from operating, investing, and financing activities, which was identified as "Net Cash Flows from Continuing Operations," Ryder inserted a separate line "Net Cash Flow from Discontinued Operations." Therefore, Ryder actually separated its cash flows into continuing and discontinued operations.

Extraordinary Gains and Losses. Excellent examples of the reporting of extraordinary gains and losses on the statement of income and the statement of cash flows can be found in the 1988 and 1989 financial statements of Panhandle Eastern Corporation. An extraordinary gain of $14.8 million was subtracted on the 1988 statement of cash flows and an extraordinary loss of $29.2 million in 1989 was added to net income on the statement of cash flows to compute cash flows from operating activities.

Change of an Accounting Principle. Since the cumulative effect of a change in accounting principle appears below income from continuing operations on the statement of income, such an effect may have to be reflected in the statement of cash flows if the statement begins with net income.

Philadelphia Electric Company and Pitney-Bowes used this procedure on their statements of cash flows. Philadelphia Electric's income statement adjustment for the cumulative effect of accounting changes was a credit of $108 million in 1990, and Pitney-Bowes' adjustment was a debit of $66 million in 1989. Accordingly in the statement of cash flows there was a subtraction from net income in 1990 for Philadelphia Electric and an addback to net income in 1989 for Pitney-Bowes.

Equity Earnings of Unconsolidated Investments. Earnings from many unconsolidated investments require an adjustment to income to compute cash flows from operating activities. When the equity method is used, the company records its share of the investee's earnings with a debit to the investment account and a credit to revenue. The actual cash flow is the amount of cash dividends received, not the share of earnings that was included as revenue. Net income must be adjusted for the difference between the cash dividends received and the amount recorded as income. The selected accounts from American Cyanamid's statements for the years 1988 to 1990, shown in Figure 1, are excellent illustrations.

In 1988 and 1989, the company deducted $19.4 million and $21.5 million in computing cash flows from operating activities. For 1990, it added the $.4 million to compute cash flows.

Knight-Ridder, Inc., had similar adjustments to net income. For two years, 1988 and 1990, it deducted "Distributions from Investee Less Than Earnings" from net income to determine cash flows from operating activities. In 1989, Knight-Ridder added "Distributions From Investee in Excess of Earnings" to determine cash flows from operating activities.

Self-Insurance An infrequently encountered item that is used in adjusting income to reflect cash flows from operating activities is the provision for self-insurance. Because this is a noncash expense, the effect on cash flows should be recognized in the reporting of cash flows from operating activities. American Store Company and Albertson's reported self-insurance expense while showing the liability on their statements of financial position. The liabilities were divided into current and long-term, based on the estimated timing of the projected losses.

Treasury Stock Issued for Compensation. The purchase of treasury stock and the issuance of stock is properly reported in the financing section of the statement of cash flows. However, there are some circumstances that require an adjustment in the cash flows from operating activities section. The issuance of treasury stock for employee stock plans and executive compensation requires such an adjustment because the transaction increases operating expenses of the period but does not involve an outflow of cash. Roadway Services, Inc., reported an adjustment of cash flows from operating activities in 1988, 1989, and 1990 for "Issuance Of Treasury Stock For Stock Plans." Roadway added the fair value of the treasury stock to the net income in computing cash flows from operating activities.

Funding of Pension Costs. Transactions related to the funding of pension plans may also require an adjustment in the cash flows from operating activities section. The amount charged to pension expense will often differ from the actual amount funded. The amount charged to pension expense on the statement of income is based on the computations as detailed in SFAS 87. The difference between pension expense and actual funding is an accrued liability if the expense exceeds funding. In the cash flows from Operating activities section, net income must be adjusted because the unfunded pension cost reduced net income but did not result in an outflow of cash. BellSouth Corporation reported this type of adjustment in 1988, 1989, and 1990. BelISouth's adjustment for "Pension Expense in Excess Of (Less Than) Funding" was an addition to net income of $126 million in 1990 and $35 million in 1988. However, in 1989 the adjustment was a reduction of net income of $46 million because the amount funded exceeded pension expense.

Capitalization of Interest. A company that capitalizes interest must give it special consideration in the preparation of a statement of cash flows. The capitalized interest was paid, therefore it was a cash outflow but it was not an expense on the statement of income. The amount reported as interest expense does not include the capitalized portion. The company must include the capitalized interest as a cash outflow in the investing activities section. Companies use different procedures to handle this reporting.

Phelps Dodge disclosed its capitalized interest in the investing activities section as a separate item, titled "Capitalized Interest." On Phelps Dodge's statement of income, it computed interest expense by reporting total interest incurred less capitalized interest. Because the capitalized interest does not affect net income, no adjustment is needed in the operating activities section.

Bethlehem Steel made all of its disclosures regarding capitalized interest in a note to the financial statements. In the note, Bethlehem reported total interest incurred as interest expense but subtracted capitalized interest to compute its "Net Financing Expense." "Net Financing Expense" was reported on the statement of income and the capitalized interest was included in capital expenditures in the investing activities section. Therefore, capitalized interest was not a separate item on either the statement of income or the statement of cash flows.

Beware the Unusual

Net income or income from continuing operations is usually adjusted for noncash expenses such as depreciation, amortization and depletion of operational assets to compute cash flows from operating activities. Adjustments to net income or income from continuing operations may also include unique items. Some infrequently encountered adjustments may appear on an individual company's statement of cash flows year after year. An example is the adjustment for the difference between the amount of revenue recorded by the investor, based on its equity. in the earnings of the investee, and dividends received by the investor. Some adjustments on the statement of cash flows, such as the issuance of treasury stock for compensation, may appear a few years and then disappear. Other adjustments on the statement of cash flows, such as the results of discontinued operations or an extraordinary loss, usually appear only one year. Accountants should be aware that atypical items reported on the statement of income may require special consideration on the statement of cash flows.

By Keith Smith, PhD, CPA, Assistant Professor of Accounting; Robert Whitis, DBA, CPA. Associate Professor of Accounting; and Coy London, PIti), CPA, Associate Professor of Accounting all from Arkansas State University

FIGURE1

IN

(millions)

FiscalYear198819891990

Equityinnetearnings$24.2$29.7$10.2

ofassociatedcompanies

Dividendsreceivedn4.88.210.6

fromassociatedcompaies

$19.4$21.5

____