Analyzing Business Earnings 75- Changes in deferred-tax-valuation allowances are recorded in the tax-
adjusted additions (or deductions) section only if such changes affected
net income or net loss for the period. Evidence of an income-statement
impact will usually take the form of an entry in the income tax rate-
reconciliation schedule. - The next step is to subtotal the entries for after-tax additions and then
combine this subtotal with the amount labeled “tax adjusted additions.”
The result is then recorded on the “total additions” line at the bottom of
the first page of the worksheet. - Completion of page 2 of the worksheet, for nonrecurring revenues and
gains, follows exactly the same steps as those outlined for nonrecurring
expense and loss. - With the completion of page 2, the sustainable earnings base for each
year is computed by adding the “total additions” line item to net income
(loss) and then deducting the “total deductions” line item.
ROLE OF THE SUSTAINABLE EARNINGS BASE
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 main-
tained in the future, other things equal. Baseimplies 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:
Net income is affected by transactions defined by management and termed
“special items,” which are not representative of the company’s ongoing opera-
tions. These transactions can obscure the underlying operating results for a pe-
riod and affect comparability of operating results between periods.^48APPLICATION OF THE SUSTAINABLE EARNINGS BASE
WORKSHEET: BAKER HUGHES INC.
This case example of using the SEB worksheet is based on the 1997 annual re-
port of Baker Hughes Inc. and its results for 1995 to 1997. The income state-
ment, statement of cash f lows, 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 ad-
here to the search sequence outlined in Exhibit 2.3.