Abstract
Most proponents of using profit margins in forecasting models suggest that unusual items be removed from income to create a core profit margin. We investigate the appropriateness of this assumption over short and long horizons. Specifically, we explore the association between profit margins and special items over windows of increasing length, from one to five years. We find that the association between past special items and future profit margins differs markedly between firms with low and high core profitability. For low profitability firms, past special items have no association with future profit margins, even over windows of five years. In sharp contrast, for high profitability firms, negative special items are associated with lower future profit margins. This suggests that some firms maintain high core profitability by becoming serial chargers and special items differ from core earnings only to the extent that the allocation process induces timing errors in reported earnings.
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Notes
Graham and Dodd, in their classic Security Analysis, alluded to this possibility: “The dangers of being misled by big bath accounting make it necessary for the analyst to review financial statements covering a history of at least 5 to 10 years before reaching a conclusion about the profitability of a company…” Graham et al. (1988). “Security Analysis: Principles and Technique.” New York: McGraw-Hill Professional.
A limitation of our study is that accounting standards were not constant over our sample period. In sensitivity tests, we provide evidence on the robustness of our findings to different periods (see Sect. 5.2).
HP’s quarterly earnings announcements prominently disclose “non-GAAP” operating profit which excludes special items. In addition, these results are discussed in the CEO letter of the annual reports for 2005 through 2007. The CEO explains that management uses the operating profit before special items to evaluate and forecast HP’s performance and that the special charges are “considered by HP’s management to be outside of HP’s core business segment operating results.”
Ohlson and Penman (1992) use a similar methodology to investigate the correlation between changes in market values and the different components of earnings measured over periods longer than a year.
Although we believe the assumption of a 35% effective tax rate for low profitability firms may lead to incorrect inferences about the association between special charges and future profitability, we ran tests using after tax income calculated assuming a 35% tax rate on negative special items. The untabulated results for the pooled sample and the high profitability firms are similar to those reported here. For the low profitability firms, tax-effected negative special items are associated with significantly higher after-tax profitability in future periods.
Givoly and Hayn (1994) discuss the research issues arising from the use of Compustat data to identify special items. (Working paper, University of California at Irvine, “Special Items: Information Content and Earnings Manipulations.”) We provide evidence in Sect. 5 on the stability of the results over time and on the specific items reported by a sample of low and high profitability firms.
We repeated the main tests using a size cutoff of $1 million and $10 million. The results are similar to those reported in the paper.
These patterns were similar for firms with low, medium, and high core profitability. All three groups exhibited increased reporting of negative special items over time and generally stable magnitudes of the special items.
Compustat nets positive and negative items within a year. We extend this procedure to all aggregation periods. We also conducted tests in which positive and negative SPECIAL items were summed independently over each window, so that a firm could have both a positive SPECIAL item and a negative SPECIAL item in any window (except in the one year window, where the Compustat data precludes this option). The conclusions in this paper are not affected by this alternative treatment.
The F-statistic is 1.19 for the difference (p-value = 0.277).
Simple nonparametric tests pooled over years suggest that low RNOA firms taking charges benefit in future years while high RNOA firms do not. These nonparametric tests did not control for the magnitude of the special items nor for the level of CORE PM.
In unreported results, we found that sorting by core PM alone obtained weaker results than those obtained by sorting by core RNOA alone.
The results are similar to those reported if we use only negative special items as the dependent variable.
We also observe that the coefficient on core profitability is negative and significant for all window sizes indicating that, within this high profitability rank, firms with the highest profitability are more likely to take charges in future periods.
In untabulated results, we investigated whether the distribution of types of special charges (e.g. restructuring charges, asset impairments, and goodwill write-offs) differed between low core and high core firms. For the subset of firm/years for which Compustat provided this information, we found no systematic differences in the types of special items reported by low and high profitability firms. We did not have sufficient data to investigate whether the persistence differed by type of special item.
Note that our study period is mainly pre-FAS 146, which requires companies to recognize exit or disposal activity costs at the time they are incurred rather than at the commitment date.
Compustat provides detailed information about the types of special items reported beginning in 2001. There was insufficient data available for us to use it in our analyses.
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Acknowledgements
We would like to thank editor Stephen Penman, discussant Richard Frankel, and an anonymous referee for their helpful suggestions. We also appreciate the comments of Ludwig Chincarini, Carla Hayn, Prem Jain, Sok-Hyon Kang, James Ohlson, Lee Pinkowitz, Sundaresh Ramnath, Edward Riedl, Brian Rountree, Teri Yohn, as well as seminar participants at Georgetown University, The George Washington University, George Mason University, the American Accounting Association 2006 Annual Meeting, and the 2008 RAST Conference.
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Appendix
Appendix
Fiscal 2005 results from continuing operations include a $64.5 million non-cash impairment charge for the Company’s equity investment in The Hain Celestial Group, Inc. (“Hain”) and a $9.3 million non-cash charge to recognize the impairment of a cost-basis investment in a grocery industry sponsored e-commerce business venture. There was no tax benefit associated with these impairment charges. Fiscal 2005 also includes a $27.0 million pre-tax ($18.0 million after-tax) non-cash asset impairment charge related to the anticipated disposition of the HAK vegetable product line in Northern Europe early in Fiscal 2006.
Fiscal 2004 results from continuing operations include a gain of $26.3 million ($13.3 million after-tax) related to the disposal of the bakery business in Northern Europe, costs of $17.1 million pretax ($11.0 million after-tax), primarily due to employee termination and severance costs related to on-going efforts to reduce overhead costs, and $4.0 million pretax ($2.8 million after-tax) due to the write down of pizza crust assets in the United Kingdom.
Fiscal 2003 results from continuing operations include costs related to the Del Monte transaction and costs to reduce overhead of the remaining businesses totaling $164.6 million pretax ($113.1 million after-tax). These include employee termination and severance costs, legal and other professional service costs and costs related to the early extinguishment of debt. In addition, Fiscal 2003 includes losses on the exit of non-strategic businesses of $62.4 million pretax ($49.3 million after-tax).
Fiscal 2002 results from continuing operations include net restructuring and implementation costs of $12.4 million pretax ($8.9 million after-tax) for the Streamline initiative.
Fiscal 2001 results from continuing operations include restructuring and implementation costs of $101.4 million pretax ($69.0 million after-tax) for the Streamline initiative, net restructuring and implementation costs of $146.5 million pretax ($91.2 million after-tax) for Operation Excel, a benefit of $93.2 million from tax planning and new tax legislation in Italy, a loss of $94.6 million pretax ($66.2 million after-tax) on the sale of The All American Gourmet business, company acquisition costs of $18.5 million pretax ($11.7 million after-tax), the after-tax impact of adopting Staff Accounting Bulletin (“SAB”) No. 101 and Statement of Financial Accounting Standards (“SFAS”) No. 133 of $15.3 million and a loss of $5.6 million pretax ($3.5 million after-tax) which represents the Company’s equity loss associated with The Hain Celestial Group’s fourth quarter results which included charges for its merger with Celestial Seasonings.
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Fairfield, P.M., Kitching, K.A. & Tang, V.W. Are special items informative about future profit margins?. Rev Account Stud 14, 204–236 (2009). https://doi.org/10.1007/s11142-009-9084-9
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DOI: https://doi.org/10.1007/s11142-009-9084-9