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Readers of C&EN's Business pages may have noticed in last week's issue that two companies--W.R. Grace and Crompton--that regularly have appeared in our earnings stories were missing. The reason is that the two firms have stopped providing the dollar amounts of nonrecurring or extraordinary items on an after-tax basis--Grace, since it filed for bankruptcy in 2001, and Crompton, since second-quarter 2003. Reporting one-time items only on a pretax basis is at odds with what we have always wanted the earnings report to be.
Both companies, because of legal problems, have been taking large pretax charges for some time. In the 2004 fourth quarter alone, Grace says its net pretax charge to account for terms and conditions under its proposed plan of bankruptcy reorganization was $570.7 million. Crompton had pretax charges of $115.7 million for antitrust costs, facility closures, employee severance, and other things.
When C&EN developed its quarterly earnings report in 1978, we decided that the standard for company earnings would not be net profit but "after-tax earnings from continuing operations, excluding nonrecurring and extraordinary items."
There were a number of reasons why we made this decision. First, and probably most convincing at the time, was that this is the way that Wall Street investors and security analysts look at earnings. When analysts predict company earnings, the forecasts, although presented in earnings per share, use essentially the same definition that we use.
However, there were more fundamental reasons for excluding one-time items. We wanted to reflect, as closely as possible, the operations of the U.S. chemical industry. Including one-time items, which are just that--one-time items--defeats that purpose of providing readers with a continuing measure of the operating health of the industry, especially when the unusual charges or gains are large.
The difference between what a company earns on its operations and what it reports in net profit can make huge differences in how a person looks at a company, including how it compares with its peers and how it stacks up against the industry. Large one-time items can make the overall picture that C&EN tries to present--that of how the chemical industry is performing--absolutely meaningless.
For instance, in last week's earnings story, we reported that combined fourth-quarter earnings for the 24-company sample increased 45.2% over the same period in 2003. If Grace and Crompton, with one-time pretax charges that cannot be excluded from after-tax earnings, had been included with the other 24 companies, earnings would have risen only 18.6%, and the aggregate profit margin would have been 4.7% instead of 6.4%.
The exclusion of one-time items puts the companies on a fairly level playing field, allowing for comparison among them and with the group as a whole. The failure to do so is almost akin to rating an automobile's gasoline mileage against a group in which some go uphill, some go downhill, and some travel on the level, but you don't know how many are taking each different route, and you don't know how steep the hills are.
The effects of one-time charges on a company can be big. For example, Dow Chemical's earnings in the fourth quarter, excluding one-time items, increased 73.3% over the same period the year before. However, net profit, which includes the items, was up only 10.4%. Its profit margin for the quarter was 7.5% without the items and 9.4% with them.
DuPont's earnings without one-time items rose 25.3%, producing a 6.2% profit margin. When nonrecurring items are included, the company's earnings fell 56.3%, and profitability was just 4.6%.
FMC Corp. went in the other direction, as inclusion of one-time events increased earnings growth dramatically. With the items included, earnings rose 1,400%; without them, 24.3%. The company's profit margin including the items was 18.4%; without them, it was 6.6%.
Profitability ratios become extremely problematic when any one-time item is included. For instance, the ratios can be very misleading when a company sells a business. How can one calculate true return on assets when the gain from the sale is included in earnings as a percentage of assets, but the assets that were sold no longer appear on the balance sheet?
Companies do not have to report one-time items after tax, since such items are not included in the generally accepted accounting principles (GAAP) promulgated by the Financial Accounting Standards Board (FASB), the group that sets the rules for corporate accountants. But most chemical executives realize the need to include this information and will include a statement in earnings reports about it, along with a disclaimer.
DuPont's statement is typical: "Management believes that earnings before special items, a 'non-GAAP' measure, is meaningful to investors because it provides insight with respect to the ongoing operating results of the company. Special items represent significant charges or credits that are important to an understanding of the company's operations."
The use of non-GAAP items came into prominence during the accounting scandals of a few years ago, when critics charged that companies were hiding their shenanigans in one-time items. There were calls for corporations to report only on a GAAP basis in annual reports and not provide any non-GAAP information. Fortunately, this seems to have gone nowhere, but use of non-GAAP data is not encouraged by FASB. If anything, both should be reported.
Views expressed on this page are those of the author and not necessarily those of ACS.
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