Analyzing Business Earnings 93cash f lows represent recognized but unrealized gains and losses. As such, there
are no associated cash inf lows and outf lows. However, the disclosures in the
MD&A represent all of the net foreign-exchange gains and losses, both real-
ized and unrealized. These are the totals that would have been added or de-
ducted 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 cur-
rency 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 f lows. 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, fed-
eral, 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 Ex-
hibit 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 develop-
ment 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 ad-
justment 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 reduc-
tion that resulted from an IRS audit agreement. The tax rate scales the num-
bers 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 bene-
ficial 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 pro-
vide it with the capacity to exercise significant inf luence over Varco. Baker