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