NONRECURRING ITEMS IN MANAGEMENTS DISCUSSION AND ANALYSIS (MD&A)




Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is an annual and a quarterly Securities and Exchange Commission reporting requirement. Provisions of this regulation have a direct bearing on the goal of locating nonrecurring items. As part of the MD&A, the SEC requires registrants to:

Describe any unusual or infrequent events or transactions or any significant economic changes that materially affected the amount of reported income from continuing operations and, in each case, indicate the extent to which income was so affected. In addition, describe any other significant components of revenues and expenses that, in the registrant’s judgment, should be described in order to understand the registrant’s results of operations.

Complying with this regulation will require some firms to identify and discuss items that may have already been listed in other financial statements and notes. In reviewing the MD&A with a view to locating nonrecurring items, the analyst should focus on the section dealing with results of operations. Here management presents a comparison of results over the most recent three years; comparing, for example, 2001 with 2002 and 2002 with 2003 is standard.

Locating nonrecurring items in MD&A is somewhat more difficult than locating them in other places. Typically the nonrecurring items in MD&A are discussed in text and are not set out in schedules or statements. However, a small number of firms do summarize nonrecurring items in schedules within MD&A. These tend to be more comprehensive and user-friendly than piecemeal disclosures embedded in text.

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The disclosure presented earlier in Exhibit 2.1 provided a restatement of the as-reported net income of Mason Dixon Bancshares. This restatement removed the effects of all items considered by Mason Dixon to be nonrecurring. This disclosure was found in the MD&A of Mason Dixon. An additional example of the disclosure of nonrecurring items from the MD&A of Phillips Petroleum Company is presented in Exhibit 2.22. Unlike Mason Dixon, Phillips Petroleum’s schedule simply presents a listing of their nonrecurring items.

Phillips Petroleum uses the term “special items” to describe the items in Exhibit 2.22. The reluctance to refer to these items as “nonrecurring” is understandable. Four of the seven line items include amounts in each of the three

NONRECURRING ITEMS IN MANAGEMENTS DISCUSSION AND ANALYSIS (MD&A)

years. This might seem inconsistent with the term nonrecurring. Phillips Petroleum provides the following explanation of the special items:

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Net income is affected by transactions defined by management and termed special items, which are not representative of the company’s ongoing operations. These transactions can obscure the underlying operating results for a period and affect comparability of operating results between periods.

While Phillips Petroleum uses special to describe what we have referred to as nonrecurring, the above description of its special items is consistent with earlier discussion in this chapter.

Phillips provided the following discussion of the effects of the information in Exhibit 2.22 on net income:

Phillips’s net income was $609 million in 1999, up 157 percent from net income of $237 million in 1998. Special items benefited 1999 net income by $61 million, while reducing net income in 1998 by $138 million. After excluding these items, net operating income for 1999 was $548 million, a 46 percent increase over $375 million in 1998.

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The above comments reveal a sharply lower growth in profit in 1999 after adjusting for the effects of the nonrecurring (special) items. A 157% increase in net income drops to 46% after adjustment for the nonrecurring items. Notice that the above discussion refers to the adjusted net income numbers as the “net operating income.” This is consistent with the characterization of the special items as “not representative of the company’s ongoing operations.” Nevertheless, we will continue to use the term sustainable to refer to earnings that have been adjusted for nonrecurring items.

Presenting information on nonrecurring items in MD&A schedules is still a fairly limited practice but may be on the rise. Though helpful in locating nonrecurring items, such schedules must be viewed as useful complements to but not substitutes for a complete search and restatement process. Textual discussion and disclosure of the effects on nonrecurring items on earnings is far more common than user-friendly schedules. The disclosures of C.R. Bard Inc. are illustrative:

In 1999, Bard reported net income of $118.1 million or diluted earnings per share of $2.28. Excluding the impact of the after-tax gain on the sale of the cardiopulmonary business of $0.12 and the impact of the fourth quarter write down of impaired assets of $0.11, diluted earnings per share was $2.27.

Bard included information on revised results for each of the three years included in its 1999 annual report. The adjusted earnings-per-share series provides a better indicator of underlying trends in operating performance and is a more reliable base on which to develop projections of future earnings. The as-reported and revised earnings-per-share information is summarized in Exhibit 2.23. As is common, the adjusted earnings, from which the effects of nonrecurring items have been removed, are less volatile.

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NONRECURRING ITEMS IN MANAGEMENTS DISCUSSION AND ANALYSIS (MD&A)

The discussion to this point has taken us through the first six steps in the nonrecurring-items search process outlined in Exhibit 2.3. The seventh and last step illustrates how additional nonrecurring items may sometimes be located in other selected notes to the financial statements.



Frequently Asked Questions

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Ans: An “other income (expense), net,” or equivalent line item is commonly found in both the single- and multistep income statement. In the case of the multistep format, the composition of other income and expenses is sometimes detailed on the face of the income statement. In both the multi- and single-step formats, the most typical presentation is a single line item with a supporting note. Even though a note detailing the contents of other income and expense may exist, companies typically do not specify its location. Other income and expense notes tend to be listed close to the end of the notes to the financial statements view more..
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Ans: 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 nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires 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. view more..
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Ans: The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17. view more..
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Ans: Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is an annual and a quarterly Securities and Exchange Commission reporting requirement. Provisions of this regulation have a direct bearing on the goal of locating nonrecurring items. As part of the MD&A, the SEC requires registrants to: view more..
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Ans: Typically, most material nonrecurring items will have been located by proceeding through the first six steps of the search sequence in Exhibit 2.3. However, some additional nonrecurring items may be located in other notes. Nonrecurring items can surface in virtually any note to the financial statements. We will now discuss three selected notes that frequently contain other nonrecurring items: notes on foreign exchange, restructuring, and quarterly and segment financial data. Recall that inventory, income tax, and other income and expense notes have already been discussed in steps 3 to 5. view more..
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Ans: The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted to the reporting of other comprehensive income. This is a relatively new feature of the income statement and was introduced with the issuance by the FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the standard is to expand the concept of income to included selected items of nonrecurring revenue, gain, expense and loss. Under the new standard, traditional net income is combined with a new component, “other comprehensive income,” to produce a new bottom line, “comprehensive income.” view more..
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Ans: The work to this point has laid out important background but is not complete. Still required is a device to assist in summarizing information discovered on nonrecurring items so that new measures of sustainable earnings can be developed. We devote the balance of this chapter to introducing a worksheet specially designed to summarize nonrecurring items and illustrating its development and interpretation in a case study. view more..
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Ans: The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions on completing the worksheet follow: 1. Net income or loss is recorded on the top line of the worksheet. 2. All identified items of nonrecurring expense or loss, which were included in the income statement on a pretax basis, are recorded on the “add” lines provided. view more..
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Ans: The sustainable earnings base provides earnings information from which the distorting effects of nonrecurring items have been removed. Some analysts refer to such revised numbers as representing “core” or “underlying” earnings. Sustainable is used here in the sense that earnings devoid of nonrecurring items of revenue, gain, expense, and loss are much more likely to be maintained in the future, other things equal. Base implies that sustainable earnings provide the most reliable foundation or starting point for projections of future results. The more reliable such forecasts become, the less the likelihood that earnings surprises will result. Again, Phillips Petroleum captures the essence of nonrecurring items in the following: view more..
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Ans: This case example of using the SEB worksheet is based on the 1997 annual report of Baker Hughes Inc. and its results for 1995 to 1997. The income statement, statement of cash flows, management’s discussion and analysis of results of operations (MD&A), and selected notes are in Exhibits 2.27 through 2.34. Further, to reinforce the objective of efficiency in financial analysis, we adhere to the search sequence outlined in Exhibit 2.3. view more..
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Ans: The nonrecurring items located in the Baker Hughes annual report are enumerated in the completed SEB worksheet in Exhibit 2.35. Each of the nonrecurring items is recorded on the SEB worksheet. When an item is disclosed for the first, second, third, or fourth time, it is designated by a corresponding superscript view more..
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Ans: The construction of an SEB worksheet always requires a judgment call. One could, of course, avoid all materiality judgments by simply recording all nonrecurring items without regard to their materiality. However, the classification of items as nonrecurring, as well as on occasion their measurement, calls for varying degrees of judgment. Some examples of Baker Hughes items that required the exercise of judgment, either in terms of classification or measurement, are discussed next. view more..
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Ans: An estimation of the sustainable portion of earnings should be the centerpiece of analyzing business earnings. This task has become a far greater challenge over the past decade as the number of nonrecurring items has increased dramatically. This explosion has been driven by corporate reorganizations and associated activities. Some of the labels attached to these producers of nonrecurring items are restructuring, rightsizing, downsizing, reengineering, redeployment, repositioning, reorganizing, rationalizing, and realignment. view more..
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Ans: Abigail Peabody was a very well-known nature photographer. Over the years she had had a number of best-sellers, and her books adorned the coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment report and wondering why she was not better prepared. After all, she had been featured in the Sunday New York Times book section, had discussed her works with Martha Stewart, and had been the keynote speaker at the Audubon Society’s annual fund-raiser. She knew it was not her investment advisers’ fault. Their performance over the past years had been better than many of the market indixes. She wondered if she was just a poor businessperson. view more..




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