April 2000


By Lailani Moody

Late last year, the SEC staff issued Staff Accounting Bulletin 100, Restructuring and Impairment Charges. SAB 100 responds to the SEC's concern that some public companies use restructurings, purchase accounting, and impairment write-offs to manage earnings in an effort to meet market expectations or maintain earnings growth.

To limit the opportunity for such earnings management, the staff has interpreted the following accounting pronouncements narrowly in SAB 100:

* EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),"
* EITF 95-3, "Recognition of Liabilities in Connection with a Purchase Business Combination," and
* SFAS 121, Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to Be Disposed Of.

The staff also expects disclosures not explicitly required by the pronouncements. If the staff objects to a registrant's accounting for a restructuring, business acquisition, or impairment charge, it may require a restatement or begin an "informal inquiry," either of which could result in a market reaction as swift and devastating as a missed earnings estimate.

Criteria for Accounting Recognition

A restructuring plan must meet certain criteria to qualify as the basis for accounting recognition:

* The plan should be committed to by management at the level necessary to approve it;
* The plan should specifically identify all significant actions necessary to reliably estimate the related liabilities; and
* The period required to execute the plan should be short enough to make significant changes to the plan unlikely.

The staff expects restructuring liabilities to be estimated and accrued with sufficient precision that they do not provide opportunities for earnings management in the future. In addition, disclosures should make clear the components, amounts, and changes. Not all restructuring plans qualify as a basis for recognizing a liability for exit costs or involuntary employee termination benefits. SAB 100 contains explanations and illustrations of the staff's understanding of how each requirement is applied in practice.

Approval of Authorized Personnel. EITF 94-3 provides that employee termination benefits and exit costs cannot be accrued until management at the appropriate level of authority has committed to the exit or termination plan. This may be the board of directors, the chief executive officer, or the head of a division or branch--whoever is authorized to commit the company without further approval or budget authorization.

All Significant Actions Detailed. To minimize the opportunity for earnings management, the staff expects an entity to have "a comprehensive plan that has been rigorously developed and thoroughly supported" before exit costs and termination benefits are accrued. Accrual cannot begin when the plan is in the development stage. SAB 100 summarizes the staff's expectations about a restructuring plan:

* The level of detail should be comparable to the entity's operating and capital budgets.
* An absence of controls and procedures to detect, explain, and correct variances indicates the plan lacks authenticity and management commitment.
* An entity should be able to reliably estimate the nature, timing, and amount of exit costs related to significant actions of the plan. Examples of factors the entity should consider to determine whether costs can be estimated reliably are as follows:

* The estimate should represent the most likely expected outcome.
* The plan should include all significant actions and an expected timetable for their completion.
* The plan should be used to evaluate the performance of personnel executing the plan and to determine variances between planned and actual results.
* Plan documentation should include sufficient detail of all significant actions, including location, estimated costs, and expected cash flows.
* Repeated, material changes to the nature, timing, and amount of estimated exit costs and termination benefits may indicate an inability to make estimates that are sufficiently reliable to permit accrual at the commitment date.

Partial Plans Result in Partial Recognition of Ultimate Charge. For example, a registrant plans to close 100 stores and has identified and developed an exit plan with budget-line-item detail for 80 specific stores. The SEC staff would have several observations:

* Management should not accrue costs for the remaining 20 stores based on the average cost of closing the 80 identified stores.
* The registrant should consider its disclosure obligations pertaining to future plans, including disclosure in management's discussion and analysis (MD&A).
* When the registrant has identified the remaining stores and developed exit plans should those stores be accounted for as a new exit plan.

Excess Accruals May Not Be Retained as General Accruals. If the registrant in the preceding example decides in a later period not to close one of the identified 80 stores, it should reverse the related accrued costs and not retain them to cover a portion of the costs associated with the remaining 20 stores. At the end of each reporting period, the registrant should reverse any accrued amount no longer needed for its originally intended purpose through the same income statement line item used to accrue the cost. The registrant should not retain excess liability accruals as general accruals, use the accruals for other purposes, or return the accruals to earnings over time.

The registrant should charge costs actually incurred to the restructuring accrual to the extent those costs are specifically included in the estimated accrual. Also, the registrant should charge other exit costs and termination benefits to operating expense in the period incurred or in which the costs or benefits qualify for accrual and give appropriate explanation in MD&A.

To make sure that they record these necessary adjustments to liabilities on a timely basis, registrants need internal accounting controls over exit and termination liabilities, including controls to ensure that necessary adjustments are recorded on a timely basis.

One Year to Carry Out the Plan. EITF 94-3 requires the registrant to execute the plan within a period of time such that significant changes are unlikely. The SEC staff has observed that certain factors indicate a plan may not begin or be executed within that time frame:

* All significant actions have not been identified with sufficient specificity or are not reasonably estimable;
* Execution of the plan will be delayed because of events or circumstances likely to occur; and
* The registrant lacks the internal controls or information needed to detect variances and make timely adjustments.

These and other factors have led the SEC staff to conclude that "a rebuttable presumption exists that the exit plan should be completed and the exit costs and involuntary employee termination benefits incurred within one year from the commitment date."

If circumstances outside of the registrant's control, such as legal or contractual restrictions (e.g., labor union contracts), delay completion of the plan, the SEC staff believes management should be able to reasonably estimate the nature, timing, and amount of exit costs and termination benefits in spite of the delay. SAB 100 does not address how the one-year rebuttable presumption could be overcome for circumstances other than those outside management's control.

Plan Spells Out Termination Benefits and Company Communicates Details to Employees. The registrant cannot accrue benefits for employees to be terminated involuntarily unless the plan specifically identifies the following:

* Formula for determining individual employee termination benefits,
* Number of employees to be terminated, and
* Employees' job classifications or functions and locations.

Employee notification must be before the balance sheet date, in sufficient detail to permit employees to determine the type and amount of their termination benefits.

Exit Costs Cannot Benefit Continuing Activities. The SAB illustrates costs that would not qualify for accrual as exit costs because they benefit continuing activities:

* Costs to transition customers to a new product line because their product is being discontinued;
* A cash incentive program for franchisees that incur qualifying costs to upgrade equipment within the next 12 months;
* A $5 million nonrecurring, lump-sum payment to a licensor in exchange for reducing the royalty rate on licensed technology from 10% to 5%; and
* Fees to be paid to an executive search firm for successful recruiting and estimated costs to relocate new employees.

Exit costs do not include losses related to asset impairments. The closure and disposition or abandonment of a registrant's long-lived assets in connection with an exit plan is accounted for under SFAS 121, with losses reported in operations.

Disclosures Should Provide Greater Transparency

SAB 100 describes disclosures that the SEC staff often requires registrants to provide, such as the following:

* Greater disaggregation and precise labeling of exit and termination costs if presented in a note or income statement line item not specifically related to the restructuring
* Separate disclosure of the nature and amounts of certain exit costs and other restructuring charges, if material. Examples include involuntary employee terminations and related costs; changes in valuation of current assets, such as inventory write-downs; long-term asset disposals; adjustments for warranties and product returns; and leasehold termination payments.
* Disclosure and explanation in MD&A of discretionary, or decision-dependent, period costs, such as exit costs
* Disclosure of losses relating to asset impairments separate from charges based on estimates of future cash expenditures.

The staff recommends a tabular presentation.

The types of events that result in restructurings often require disclosure under the SEC's MD&A rules in periods before the costs are recorded under GAAP. Regardless of whether material exit costs and termination benefits are currently accruable in the financial statements, if the costs and benefits affect a known trend, demand, commitment, event, or uncertainty, the registrant should disclose them in MD&A. The registrant should also quantify and disclose expected effects on future earnings and cash flows, including the initial period in which they may be realized.

Liabilities Assumed in a Purchase Business Combination

The staff is concerned that some registrants may overstate liabilities assumed in purchase business combinations, thereby giving registrants discretionary reserves to use in future periods. Although this increases goodwill, presumably that asset would be amortized over fairly lengthy periods.

When the valuation of liabilities is based on estimates of future cash flows (for example, liabilities for contingencies such as warranties and environmental remediation costs), the staff's view is that the undiscounted cash flows determined by the buyer should not be materially different from those determined by the seller and reflected in its financial statements. (The fair values may differ due to different discount rates used to determine the present value of the cash flows.)

Although the staff does not suggest that the buyer use the amounts recorded by the seller if they do not represent fair value, significant differences should be investigated. If the seller's financial statements are not fairly stated, they should be restated to reflect the change in the liability in the proper period. MD&A should reflect the trends, events, and changes related to the corrected liability in appropriate periods if their effect is material to the seller's balance sheet, income statement, or cash flows.

Inventory Write-Downs

The staff believes that registrants should classify inventory write-downs in the income statement as a component of cost of goods sold, even if they are related to restructurings. As the write-down establishes a new inventory cost basis, subsequent write-ups are not permitted.

Asset Impairments and Goodwill Write-offs

The staff believes that a company should not reclassify assets for disposal until it can remove them from operations.

Under SFAS 121, assets to be disposed of are carried at the lower of their carrying amount or fair value less cost to sell. Depreciation or amortization stop when fixed assets are reclassified from assets held for use to assets to be disposed of. However, the staff believes registrants should consider the guidance below, derived from SFAS 121, APB Opinion 30, Reporting the Results of Operations, and the criteria in EITF 94-3, to determine if management's plan is "sufficiently robust":

* Management with the proper authority has adopted a formal plan of disposal before the balance sheet date.
* The plan specifically identifies all major assets to be disposed of and all significant required actions, including method, location, and expected disposal date.
* If the assets are to be sold, the entity has begun an active program to find a buyer. In the SEC staff's view, an active sales program exists only if the marketing program begins soon after the commitment date and continues until the sales transaction is complete.
* Management can estimate the proceeds expected to be realized.
* Actions to carry out the plan will begin as soon as possible after the commitment date.
* The time required to complete the plan indicates that significant changes are unlikely.

If the asset targeted for disposal cannot be removed from current operations, management should reevaluate its useful life and residual value.

Asset Impairment Does Not Equal Goodwill Impairment if Unit Remains Profitable. Suppose that a registrant acquired ABC Company, consisting of existing product lines, operations, customer relationships, future net cash flows, and four manufacturing facilities. The registrant subsequently restructured certain operations, including a planned relocation of ABC Company's manufacturing operations to other facilities. The registrant expects products, operations, cash flows, and customer relationships of ABC Company to continue undiminished.

Because the operations and business of ABC Company will continue at their expected profitability level, goodwill recognized in the acquisition is not diminished by the planned sale of the manufacturing facilities. Therefore, the SEC staff would object to the registrant allocating goodwill to the disposal of the manufacturing facilities.

Cash Flows Used to Measure Impairment. The staff uses SAB 100 to remind registrants that assumptions and judgments used to develop expected future cash flows for purposes of applying SFAS 121 should be consistent with other calculations and disclosures in the financial statements and MD&A. Those expected future cash flows should also be consistent with other forward-looking information, for example, in internal budgets, incentive compensation plans, discussions with lenders or third parties, and reports to management and the board of directors.

Methods for Evaluating Material Amounts of Goodwill. A registrant should evaluate goodwill not identified with assets that is impaired under the provisions of SFAS 121 for possible impairment at the enterprise level under APB Opinion 17, Intangible Assets.

Registrants may use the following methodologies to measure impairment of enterprise goodwill:

* Market value method. The excess, if any, of the book value of the enterprise over its market capitalization
* Undiscounted cash flow method. The excess, if any, of the book value over undiscounted expected future cash flows
* Discounted cash flow method. The excess, if any, of the book value over the present value of expected future cash flows.

Registrants should evaluate enterprise goodwill for impairment at a level that includes all operations that benefit directly from that acquired intangible, which may be the registrant as a whole. If the acquired business is managed as a separate business unit, the registrant should evaluate goodwill at the business unit level.

The staff expects registrants to make certain disclosures about how they account for enterprise goodwill if the balance of unamortized goodwill is material relative to other financial position measurements (including shareholders' equity) or if goodwill amortization expense is material relative to income statement measurements. The disclosures, which should be explicit and refer to objective, not discretionary, factors, should include the following:

* Conditions that would trigger an impairment assessment;
* Method (market value, undiscounted cash flow, or discounted cash flow) the registrant would use to measure impairment; and
* How the registrant would implement the method (i.e., how it would consider interest expense and how it would select the discount rate).

If a registrant changes the method it uses for evaluating the carrying amount of enterprise goodwill, it needs a preferability letter from its auditor. In general, the staff prefers the discounted cash flow method to the undiscounted cash flow method, and the market value method to the discounted cash flow method if the market value is reliably determinable. *

Lailani Moody, CPA, is a senior manager in the professional standards group of Grant Thornton LLP.

Gary Illiano, CPA
Grant Thornton LLP

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