54 Understanding the Numbers
The $25.7 million reduction in 1999 depreciation was not set out sepa-
rately in Southwest’s 1999 income statement, as would be the case if the
depreciation reduction resulted from a change to straight-line from the acceler-
ated method. Unlike the case of AK Steel (Exhibit 2.9), there is no cumulative-
effect adjustment in the Southwest income statement.
Southwest reported pretax earnings of $774 million in 1999. Pretax earn-
ings in 1998 were $705 million. On an as-reported basis, Southwest’s pretax
earnings grew by 10% in 1999. Without the $25.7 million benefit from the in-
crease in aircraft useful lives, however, the pretax earnings increase in 1999
would have been only 6%. That is, on a consistent basis Southwest’s improve-
ment in operating results is sharply lower than the as-reported results would
suggest. Locating the effect of this accounting change and determining its con-
tribution to Southwest’s 1999 net income is essential in any effort to judge its
1999 financial performance.
Identifying nonrecurring items in the income statement as outlined above
is a key first step in earnings analysis; many such items will be located at other
places in the annual report. The discussion that follows considers other loca-
tions where additional nonrecurring items may be located.
NONRECURRING ITEMS IN THE STATEMENT
OF CASH FLOWS
After the income statement, the operating activities section of the statement
of cash f lows is an excellent secondary source to use in locating nonrecurring
items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of
this section of the statement of cash f lows results from two factors. First,
gains and losses on the sale of investments and fixed assets must be removed
from net income in arriving at cash f low from operating activities. Second,
noncash items of revenue or gain and expense or loss must also be removed
from net income. All cash inf lows associated with the sale of investments and
fixed assets must be classified in the investing activities section of the state-
ment of cash f lows. This classification requires removal of the gains or losses
typically nonrecurring in nature from net income in arriving at cash f low
from operating activities. Similarly, because many nonrecurring expenses or
losses do not involve a current-period cash outf low, such items must be ad-
justed out of net income in arriving at cash f low from operating activities.
Such adjustments, if not simply combined in a miscellaneous balance, often
highlight nonrecurring items.
The partial statement of cash f lows of Escalon Medical Corporation in
Exhibit 2.14 illustrates the disclosure of nonrecurring items in the operating-
activities section of the statement of cash f lows. The nonrecurring items would
appear to be (1) the write-down of intangible assets, (2) the net gain on sale of
the Betadine product line, (3) the net gain on the sale of the Silicone Oil product