The Portable MBA in Finance and Accounting, 3rd Edition

(Greg DeLong) #1
Analyzing Business Earnings 37

the financial statements of many companies. As a summary exercise, a compre-
hensive case is provided that removes all nonrecurring items from reported re-
sults to arrive at a sustainable earnings series.


THE NATURE OF NONRECURRING ITEMS


Def ining nonrecurring itemsis difficult. Writers often begin with phrases like
“unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in
their popular intermediate accounting text use the term irregularto describe
what most statement users would consider nonrecurring items.^2 For our pur-
poses, irregular or nonrecurring revenues, gains, expenses, and losses are not
consistent contributors to results, in terms of either their presence or their
amount. This is the manner in which we use the term nonrecurring items
throughout this chapter.
From a security valuation perspective, nonrecurring items have a smaller
impact on share price than recurring elements of earnings. Some items, such as
restructuring charges, litigation settlements, f lood losses, product recall costs,
embezzlement losses, and insurance settlements, can easily be identified as
nonrecurring. Other items may appear consistently in the income statement
but vary widely in sign (revenue versus expense, gain versus loss) and amount.
For example, the following gains on the disposition of f light equipment were
reported over a number of years by Delta Air Lines:^3


1992 $35 million
1993 65 million
1994 2 million
1995 0 million
1996 2 million

The gains averaged about $25 million over the 10 years ending in 1996
and ranged from a loss of $1 million (1988) to a gain of $65 million (1993). The
more recent five years typify the variability in the amounts for the entire 10-
year period. These gains did recur, but they are certainly irregular in amount.
There are at least three alternative ways to handle this line item in revis-
ing results to identify sustainable or recurring earnings. First, one could sim-
ply eliminate the line item based on its highly inconsistent contribution to
results.^4 Second, one could include the line item at its average value ($25 mil-
lion for the period 1987 to 1996) for some period of time. Third, one could at-
tempt to acquire information on planned aircraft dispositions that would make
possible a better prediction of the contribution of gains on aircraft disposi-
tions to future results. While the last approach may appear to be the most
appealing, it may prove to be difficult to implement because of lack of infor-
mation, and it may also be less attractive when viewed from a cost-benefit per-
spective. In general, we would normally recommend either removing the gains

Free download pdf