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.
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
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.
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.