Fin 7573 Professor Parrino

Helpful Hints
Adjusting Net Income for non-recurring expenses in Comparable Company Analysis

At first blush, adjusting comparable data for non-recurring expenses seems like an easy task. All
you have to do is find the non-recurring expenses listed in the income statement (restructuring
charges, merger expenses, etc.) and add them back as if they never existed. Unfortunately since
some of these items impact both the actual taxes paid and the tax expense reported in GAAP
statements, the analyst must include the tax impacts in the adjustments. This is not always a
straightforward task. Let’s walk through an example to illustrate the steps in the adjustment.

Suppose the comparable company being examined has the following income statement:

Table 1:

Sales 100
CGS -70
SGA -10
Merger Exp -10

Operating Income (EBIT) 10

Tax -4

Net Income 6

In this case assume the merger expenses on income statement are deductible for both tax and
GAAP purposes (more on that later). Before using the above company comparable, the analyst
will want to adjust the statements to eliminate the merger expenses since these are non-recurring
expenses that are unlikely to be part on on-going operations. The EBIT adjustment is very
straight forward since this variable is before any taxes are estimated. To adjust EBIT simply add
back the merger expenses to the recorded EBIT. In this case the adjusted EBIT is 20. The
adjustment to net income requires the analyst to examine how the merger expenses impacted the
tax expense. In this case since we assume the merger expenses are deductible for both tax and
GAAP, the adjustment to net income is the add back of the merger expense net of tax (6 + 10*(1-
.4)= 12)). The adjusted net income of $12 reflects what the statement would have been if merger
expenses did not exist.

Now suppose that the merger expenses were not deductible for tax purposes or GAAP purposes.
It is not worth our time here to examine the differences in tax treatment for GAAP versus actual
tax books reported to the IRS. That is a course by itself. All we need here is to know that
whatever differences exist will be detailed in the tax footnote to the financial statements. This
footnote will provide you with the effective tax rate which is needed to correctly calculate our
adjustments. Let’s assume the financial statements are as follows:

Table 2

Sales 100
CGS -70
SGA -10
Merger Exp -10

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Operating Income (EBIT) 10

Tax -8

Net Income 2

In this example, the tax rate on the income statements appears to be 80% (8/10). However a
closer look at the tax footnote would tell us that the merger expenses were not deductible and the
effective tax rate is 40%. Thus the proper adjustment is to simply add back the merger expenses
to net income for an adjusted net income of 12 (10+2). Notice the adjusted net income is the
same as the first example. This makes sense because in both scenarios we are eliminating all
impacts of the merger expenses and the income statements are identical except for the tax
treatment of merger expenses.

Let’s try one more scenario with the same company. Suppose that the income statement looks
like Table 3. Now suppose that in the tax footnote you read that only 50% of the merger expenses
are deductible for tax purposes and that the effective tax rate is 40%. To eliminate the effect of
the merger expenses on net income in this scenario, we must adjust the tax impact to include the
accurate effective tax rate on the merger expenses. If only half of the merger expenses are
deductible, then the tax savings rate resulting from the deduction is 20% (or 5/10 * 40%). This
of course assumes that we have carefully checked the footnote which tells us that the overall
effective tax rate is 40% (not 60% as it would appear by only examining the income statement).
To adjust net income the add back of merger expenses should be (10 *(1- .2)) or $8. Adjusted
net income is $4 + $8, or $12. As expected the adjusted income is the same as in the previous
scenarios.

Table 3:

Sales 100
CGS -70
SGA -10
Merger Exp -10

Operating Income (EBIT) 10

Tax -6

Net Income 4

Now let’s try it with a real life example using Project Hot Wheels. Assume the date is December
15, 1998 and we want to estimate the LTM Net Income for Electronic Arts (ERTS). Given the
information available at the time, LTM Net Income is computed by taking FY97 plus 6 months
ended September 98 less 6 months ended September 97. The data from the respective 10K and
10Q is included in Exhibit 1.

The trouble begins in 1997 where merger related expenses and write-offs of in process
technology sum to $12.29 million ($10.792+$1.5). Since these expenses are non-recurring, we
want to add them back or eliminate their effects on net income before using net income as a
comparable price parameter. The tax footnote in the 10K suggests the effective tax rate is 35%

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and gives no indication that these expenses are not deductible for tax purposes. Following the
logic from the above examples, the adjustment to net income should be $7.99 million (12.29 * (1-
.35)). In other words, without the non –recurring expenses, profit before tax would be $12.29
million higher, but taxes would be $4.30 higher ($12.29 * .35), resulting in a net increase to net
income of $7.99 million. Adjusted net income for FY 97 is $80.55 million.

In the 10k for the six months ended September 98, things get messier. The tax footnote tells us
that the effective tax rate is 33% and that some of the $44.1 million in write-offs for in process
technology are not tax deductible (see Exhibit 2). Unfortunately the exact amount of the write-
offs that are deductible is left to the reader of the financial statements to estimate. One method to
adjust the Net Income is simply to re-cast the income statement without the $44.1 million in
write-offs, using the effective tax rate of 33%. This would provide the following adjusted income
statement:

Table 4:
ERTS
6 Months Ended September 30, 1998

Actual Adjusted

Sales 423.984 423.984

CGS 221.888 221.888
SGA 184.476 184.476
Write-off of in process tech 44.115

Operating Income (EBIT) -26.495 17.62

interest and other 6.565 6.565
Income before Tax -19.93 24.185
Tax -1.372 -7.98105

Net Income before Minority -21.302 16.20395

Interest
Minority Interest -0.271 -0.271
Net Income -21.573 15.93295

Another approach would be to estimate the amount of the $44.1 million write-off that is non-
deductible, and adjust the add-back accordingly. This approach requires a little thought, but may
provide for more efficient spreadsheet models by reducing the adjustment to a single formula.

Reported Taxes 1.37

Income Before tax excluding non-deduct write-offs 4.16 (1.37/.33)
Non decutible portion of write-offs 24.09 (-19.93-4.16)
Deductible portion of write-offs 20.03
Percentage of write-offs that are deductible 45%
Tax Savings Rate of total write- 15% (45% * 33%)
off
Add back adjustment 37.50 (44.1 * (1-.15))
Reported Net Income -21.57

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Adjusted Net Income 15.92

The last step in LTM Net Income Calculation for ERTS is to subtract the Net Income for the six
months ended September 1997. The 10Q shows merger expenses of $10.79 million. These are
the same merger expenses we adjusted for in FY ended 1998. The add-back adjustment is simply
$10.79 * (1-.35) or $7.01 million. The adjusted Net Income for the six months ended September
1997 is therefore $5.6 million. Finally, putting everything together, the LTM Net Income for
ERTS is:

$80.55 + $15.93 – $5.6 = $90.88 million

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Exhibit 1 – Data from 10k and 10q

ELECTRONIC ARTS AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

Years Ended March 31,

1998 1997 1996
------------------------------------------------------------------------------------------------------------------------

Net revenues $908,852 $673,028 $587,299

Cost of goods sold 480,766 328,943 291,491
--------------------------------------------------

Gross profit 428,086 344,085 295,808

taxes
Operating expenses:
Marketing and sales 128,308 102,072 85,771
General and administrative 57,838 48,489 37,711
Research and development 146,199 130,755 108,043
Charge for acquired in-process technology 1,500 - 2,232
Merger costs 10,792 - -
--------------------------------------------------
Total operating expenses 344,637 281,316 233,757
--------------------------------------------------

Operating income 83,449 62,769 62,051

Interest and other income, net 24,811 13,279 7,514
--------------------------------------------------

Income before provision for income taxes and minority interest 108,260 76,048 69,565
Provision for income taxes 35,726 26,003 22,584
--------------------------------------------------

Income before minority interest 72,534 50,045 46,981

Minority interest in consolidated joint venture 28 1,282 (304)
--------------------------------------------------

Net income $72,562 $51,327 $46,677

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Exhibit 1 Continued
ELECTRONIC ARTS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(unaudited)

Three Months Ended Six Months Ended

September 30, September 30,
1998 1997 1998 1997
-------------------------------------------------------------------------

Net revenues $245,763 $189,828 $423,984 $313,540

Cost of goods sold 134,299 103,641 221,888 165,953
------- ------- ------- -------
Gross profit 111,464 86,187 202,096 147,587
------- ------- ------- -------
taxes
Operating expenses:
Marketing and sales 33,523 29,032 67,167 55,668
General and administrative 16,395 13,191 31,812 25,080
Research and development 48,349 36,252 84,591 63,934
Amortization of intangibles 906 - 906 -
Charge for acquired in-process technology 41,836 - 44,115 -
Merger costs - 10,792 - 10,792
------- ------- ------- -------
Total operating expenses 141,009 89,267 228,591 155,474
------- ------- ------- -------
Operating loss (29,545) (3,080) (26,495) (7,887)
Interest and other income, net 3,750 3,142 6,565 5,692
------- ------- ------- -------
Income (loss) before provision for income
taxes and minority interest (25,795) 62 (19,930) (2,195)
Provision (benefit) for income taxes (563) 21 1,372 (757)
------- ------- ------- -------
Income (loss) before minority interest (25,232) 41 (21,302) (1,438)

Minority interest in consolidated

joint venture (41) - (271) 28
------- ------- ------- -------
Net income (loss) (25,273) $ 41 $(21,573) $ (1,410)
======= ======= ======= =======

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Exhibit 2 – Tax Footnote from 10Q

Income Taxes
income
September 30, September 30,
1998 1997 % change
------------------- ------------------- -----------
---

Three Months Ended ($563,000) $ 21,000 N/M

effective tax rate 2.2% 34.5%

Six Months Ended $1,372,000 ($757,000) N/M

effective tax rate (6.9%) 34.5%

The Company's effective tax rate for the three and six months ended September
30, 1998 was negatively affected as there was no tax benefit recorded for a
portion of the charges related to the acquired in-process technology. Excluding
the effect of these charges, the effective tax rate for the three and six months
ended September 30, 1998 would have been 33.0% as compared to a 34.5% tax rate
in the corresponding prior year periods. The lower rate of 33.0% results
primarily from having a higher estimated proportion of international income
subject to a lower foreign effective tax rate for the fiscal year.

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