Analyzing Business Earnings 59precious metal inventories valued under the LIFO method. The after-tax effect
on continuing operations for 1996 and 1997 amounted to $19,260,000 ($1.40 per
basic share) and $3,717,000 ($.31 per basic share), respectively.^24The effect of the Handy and Harman LIFO liquidation is quite dramatic.
Including the effects of the LIFO liquidations, Handy and Harman reported
after-tax income from continuing operations of $33,773,000 in 1996 and
$20,910,000 in 1997. Of the after-tax earnings from continuing operations 57%
in 1996 and 18% in 1997 resulted from the LIFO liquidations. Handy and Har-
man reported benefits from LIFO liquidations for most years between 1991
and 1997.
Although Handy and Harman reported LIFO liquidations with some reg-
ularity, an analysis of sustainable earnings should consider the profit improve-
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 INCOME 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
with the amount that would have resulted if all pretax results had been taxed at
the statutory federal rate. This disclosure for Archer Daniels Midland Com-
pany (ADM) is presented in Exhibit 2.18.
Notice that ADM’s effective tax rate is reduced in 2000 by 17 percentage
points as a result of redetermining taxes in prior years. This percentage reduction