SOME FURTHER POINTS ON THE BAKER HUGHES WORKSHEET




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.

The Petrolite Inventory Adjustment

A pretax addition was made in Exhibit 2.35 for the effect on 1997 earnings of inventory obtained with the Petrolite acquisition (see Exhibits 2.30 and 2.34). Accounting requirements for purchases call for adjusting acquired assets to their fair values. This adjustment required a $21.9 million increase in Petrolite inventories to change them from cost to selling price. This meant that there was no profit margin on the subsequent sale of this inventory in the fourth quarter of 1997. That is, cost of sales was equal to the sales amount. Baker Hughes labeled this $21.9 million acquisition adjustment “nonrecurring charge to cost of sales for Petrolite inventories” (see segment disclosures in Exhibit 2.34).

This Petrolite inventory charge raised the level of cost of sales in relationship to sales. However, this temporary increase in the cost-of-sales percentage (cost of sales divided by sales) was not expected to persist in the future. We concurred with the Baker Hughes judgment and treated this $21.9 million cost-of-sales component as a nonrecurring item in developing sustainable earnings.

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Foreign Exchange Gains and Losses

Information on foreign exchange gains and losses was disclosed in the statement of cash flows (Exhibit 2.28) and in the MD&A (Exhibit 2.30). The statement of cash flows disclosed foreign-currency losses of $1.9 million in 1995 and $8.9 million in 1996. A $6.1 million gain was disclosed in 1997. However, the MD&A disclosed a foreign-currency loss of $11.4 million for 1996 and a gain of $4.1 million for 1997. The foreign-currency items in the statement of cash flows represent recognized but unrealized gains and losses. As such, there are no associated cash inflows and outflows. However, the disclosures in the MD&A represent all of the net foreign-exchange gains and losses, both realized and unrealized. These are the totals that would have been added or deducted in arriving at net income and also represent the nonrecurring foreign currency gains and losses.

For 1996 and 1997, the Baker Hughes worksheet includes the foreign currency gain and loss disclosed in the MD&A, a loss of $11.4 million for 1996 and a gain of $4.1 million for 1997. In the absence of a disclosure of any foreign currency gain or loss in the MD&A for 1995, the worksheet simply included the $1.9 million loss disclosed in the statement of cash flows. Adjusting the foreign-currency gains and losses out of net income is based on a judgment that comparative performance is better represented in the absence of these irregular items.

The Tax Rate Assumption and Acquired R&D

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The tax rate used in the Baker Hughes worksheet was a combined (state, federal, and foreign) 42%. This is the three-year average effective tax rate for the company once nonrecurring tax items were removed from the tax provision. Two nonrecurring tax items stand out in the income tax disclosures in Exhibit 2.29. First is the increase in the tax provision because of the lack of tax deductibility of the $118 million of acquired in-process research and development in 1997.49 The tax effect of this nonrecurring item, $41.3 million, pushed the effective rate up to 49% for 1997. Because of this lack of deductibility for tax purposes, the pretax and after-tax amounts of this charge are the same, $118 million. Therefore, we recorded the $118 million charge with the other tax and after-tax items in the bottom section of the SEB worksheet. Because this item is added back to net income on its after-tax basis, no additional adjustment was needed for the $41.3 million tax increase resulting from the lack of deductibility.

The second adjustment was for the $11.4 million nonrecurring tax reduction that resulted from an IRS audit agreement. The tax rate scales the numbers in the worksheet to their after-tax amounts. The goal should be a rate that is a reasonable representation of this combined rate. It is usually not cost beneficial to devote an inordinate amount of time to making this estimate.

Equity Earnings and Disposal of the Varco Investment

The MD&A included discussion of the gain on the sale of the Varco investment. This is a clear nonrecurring item, and it was adjusted from results in the Baker Hughes SEB worksheet. Baker Hughes accounted for its investment in Varco by using the equity method. This indicates that its ownership was sufficient to provide it with the capacity to exercise significant influence over Varco. Baker Hughes disclosed that it recognized equity income from Varco of $3.2 million in 1995 and $1.8 million in 1996. However, the disposal of the Varco investment did not qualify as a discontinued operation. If it had been so classified, then the Baker Hughes share of earnings would have been removed from income from continuing operations of 1995 and 1996 and reported with discontinued operations—along with the gain on the disposition of the investment.

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Clearly, a case could be made for treating the 1995 and 1996 equity earnings as nonrecurring and removing them from earnings in developing the SEB worksheet. This would not alter the message conveyed by the SEB worksheet in this particular case. However, if the effect were more material, then a judgment to treat as nonrecurring the equity earnings from the Varco investment would be in order.

Using the Summary Disclosures of Unusual Charges

In completing the worksheet, the summary totals from the unusual-charge disclosures (Exhibit 2.33) were used. Alternatively, the detail on the charges could have been recorded in appropriate lines in the worksheet. We saw this as offering no advantage here.

Having the detail on the makeup of the unusual charges is helpful in determining whether other additional nonrecurring items have already been included in these totals. Recall that the 1997 Petrolite inventory adjustment of $21.9 million was not included in the unusual charges total (it was included in cost of sales). Summaries for unusual charges, it should be noted, usually do not include all items that could reasonably be considered nonrecurring. In addition, care should be taken not to duplicate the recording of items already included in summary totals for unusual charges.

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Frequently Asked Questions

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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: 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 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: 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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