Costs Associated with Exit or Disposal Activities

By Robert A. Dyson

In Brief

New Guidance Emphasizes Fair Value

SFAS 146 covers those costs associated with exit and disposal activities that are not covered by SFAS 144. SFAS 146 generally requires the recognition of an expense and related liability for one-time employee termination benefits at the communication date and contract termination costs at the cease-use date. Thus, SFAS 146 eliminates the EITF 94-3 requirement to recognize a liability when management approves an exit or disposal plan, specifically noting that an entity’s commitment at the initiation date does not, by itself, require the recognition of a liability. The expense and liability are measured at fair value, which is generally determined by estimating the future cash flows to be used in settling the liability, discounted at a credit-adjusted risk-free rate of interest.

In June 2002, FASB issued SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, to provide guidance on the measurement and recognition of a liability and related expense for costs associated with exit or disposal activities. SFAS 146 nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring), which previously provided guidance in this area, and supersedes EITF 88-10, Costs Associated with Lease Modification or Termination. SFAS 146 is reflected in 2003’s Staff Accounting Bulletin (SAB) 103, “Codification of Staff Accounting Bulletin.”

In applying SFAS 146, financial statement preparers and auditors must understand several important dates. The initiation date is the date that management, having the authority to approve an action, commits to an exit or disposal plan which, if the activity involves the termination of employees, meets the following
criteria:

The communication date is the date on which the exit or disposal plan has been communicated to the affected employees. The cease-use date is the date on which the contract is terminated in accordance with the terms or when the rights conveyed by the contract are no longer used. The termination date is the date on which the activity is exited.

Scope

One example of an SFAS 146 exit activity is restructuring, as defined in International Accounting Standard (IAS) 37, Provisions, Contingent Liabilities and Contingent Assets. IAS 37 defines restructuring as a program planned and controlled by management that materially changes either the scope of the business or the manner in which the business is conducted. A restructuring defined by IAS 37 includes the sale or termination of a line of business, the closure of business activities in a particular location, the relocation of business activities from one location to another, changes in a management structure, and a fundamental reorganization that affects the nature and focus of operations. EITF 94-3 did not define restructuring, but classified certain individual costs typically included in restructurings as exit costs.

SFAS 146 applies to costs associated with an exit activity, including the following:

SFAS 146 does not apply to costs associated with the following:

SFAS 146 is effective for exit and disposal activities initiated after December 31, 2002, with early application encouraged. Previously issued financial statements will not be restated. Prior to implementing SFAS 146, financial statement preparers should continue to apply EITF 94-3 to exit activities already initiated. An exit or disposal activity is considered initiated on the initiation date, as discussed above. Thus, an entity would account for a restructuring in accordance with EITF 94-3 if it initiated that transaction prior to January 1, 2003, and completed it after December 31, 2002. If an entity initiates a restructuring in 2002 and a second restructuring in 2003, it would account for the 2002 restructuring in accordance with EITF 94-3 and the 2003 restructuring in accordance with SFAS 146.

Recognition and Measurement

General rule. Liabilities for costs associated with an exit or disposal activity are recognized and measured initially at their fair values during the period in which an obligation meets the definition of a liability. FASB Concept Statement 6, Elements of Financial Statements, defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.” Thus, SFAS 146 requires the recognition of a liability and related expense when a transaction or event occurs that leaves an entity little or no discretion to avoid the future transfer or use of assets to settle the liability. The liability itself consists of future cash flows expected to be incurred in the exit and disposal activity, which are discounted at a credit-adjusted risk-free interest rate.

SFAS 146 generally requires the recognition of costs related to one-time employee termination benefits at the communication date and contract termination costs at the cease-use date. An entity is probably irrevocably committed to the exit and disposal plan on the communication date because, at that time, employees can be expected to look for new jobs and may not be available if the entity revises its plan. Thus, SFAS 146 eliminates the EITF 94-3 requirement to recognize a liability when management approves an exit or disposal plan, specifically noting that an entity’s commitment to an exit or disposal plan at the initiation date does not, by itself, require the recognition of a liability. The reasoning appears to be that an entity may keep an exit or disposal plan confidential at the initiation date and could always cancel the plan, prior to public announcement, with no impact on operations. Similarly, the entity is unlikely to attempt to reverse a decision to terminate a contract after the cease-use date.

The fair value of a liability for a cost associated with an exit or disposal activity is generally determined by estimating the future cash flows expected to be used in settling the liability, discounted at a credit-adjusted risk-free interest rate. (FASB acknowledged that, in most cases, quoted market prices, ordinarily the best means of determining fair value, do not exist for this type of liability.) At the initiation date, management should have sufficient information to make a reasonable estimate of the cash expenditures relative to the termination benefits, such as the identity, length of service, and wages of each employee to be terminated; the expected date of termination; the number of employees affected; and the termination benefits to be provided. Similarly, management should have sufficient information to estimate the cash expenditures of early termination of any contracts, whose provisions should ordinarily specify such information as future minimum payments, any contingent payments, and penalties for early termination. In circumstances where the fair value cannot be reasonably estimated, the liability is initially recognized in the period in which the fair value can be reasonably estimated. FASB considers these circumstances unusual, which effectively places the burden of proof on whoever is asserting that a liability cannot reasonably be estimated. An exception to this recognition criterion pertains to termination benefits requiring employees to perform future services.

The second element in estimating the costs associated with an exit or disposal activity is a risk-free interest rate adjusted to reflect the reporting entity’s credit rating. SFAS 146 does not define “credit-adjusted risk-free interest rate,” but each component of that rate can be determined. SFAS 123, Accounting for Stock-Based Compensation, describes a risk-free interest rate as the interest rate currently available on zero-coupon U.S. government securities with a remaining term equal to the expected term of the instrument in question. The adjustment to that rate reflecting an entity’s credit rating is often available in the entity’s long-term debt agreements. Many financial institutions provide loans with a variable interest rate based on some widely used measure, such as LIBOR or prime, plus a fixed risk factor. For example, assume an entity enters into a long-term debt arrangement requiring an interest rate of LIBOR plus 2%. In this case, the 2% risk factor would be the credit adjustment to the risk-free interest rate to arrive at a credit-adjusted risk-free rate of interest. Some entities have several long-term debt payables outstanding at a given time, each with a different risk factor. In those instances, the risk factor most representative of the incremental credit risk associated with the entity should be selected, such as that required by the most recent debt obtained.

Reporting entities should not apply SFAS 5, Accounting for Contingencies, in determining the period in which to recognize exit or disposal expense and in measuring the fair value of that expense and related liability. SFAS 5 requires the accrual of a loss if, among other things, information indicates that it is probable that a liability has been incurred at the date of the financial statements and the amount of that loss can be reasonably estimated. Although SFAS 146 is silent on this matter, the author believes that exit or disposal activities, if announced but not accrued before the issuance of the financial statements, should be disclosed as a subsequent event. The disclosure should include the estimated costs of the exit or disposal activity.

Employee termination benefits. Costs associated with an exit activity include termination benefits provided in a one-time benefit arrangement to current employees that will be involuntarily terminated. A one-time benefit arrangement is established by a plan on the initiation date and is recognized on the communication date, unless services are required beyond a minimum period.

The timing of recognition and the related measurement of a liability for one-time termination benefits depends upon whether employees are required to render services until they are terminated in order to receive the benefits and, if so, whether they will be retained to render those services beyond a minimum retention period. The minimum retention period is the legal notification period, the advance notice an entity must provide employees of a specified termination event required by law or contract. Federal law requires 60 days’ notice in certain circumstances, but labor contracts may require a longer period.

A liability for termination benefits is recognized and measured at the communication date if employees are entitled to receive the benefits regardless of when they leave or if they will not be retained beyond a minimum retention period. A public promise to the employees is sufficient to recognize a liability. The promise can be unconditional or conditioned upon events either within or beyond the entity’s control, written or oral, or inferred from the entity’s past practice, absent any announcements from the entity to the contrary (Exhibit 1).

If employees are required to render services beyond the minimum retention period in order to receive termination benefits, the entity should initially measure (but not recognize) a liability at the communication date, based on its fair value as of the termination date. The liability and related expense are recognized ratably over the future service period. Changes over time are recognized as an increase in the liability and as an accretion expense. The accretion expense is not considered an interest expense for financial reporting purposes or when measuring capitalized interest (Exhibit 2).

In the periods subsequent to the initial measurement, the liability may be revised to reflect changes in the estimates of the timing or amount of estimated cash flows. The entity should first estimate the future cash flows for the revised ultimate liability as of the communication date, discounted at the credit-adjusted risk-free interest rate used in measuring the initial liability. The cumulative effect of changes due to revisions in estimates of the timing or amount of estimated cash flows are recognized, in the period the estimates were revised, as an adjustment to the recorded liability and in the same line item(s) in the income statement used when originally recognized. FASB does not require periodic evaluation of the liability, but does note that it anticipates that liabilities associated with exit or disposal activities are generally short-lived (Exhibit 3).

If the plan of termination changes, and employees that were expected to be terminated within the minimum retention period are retained to render services beyond that period, the liability originally recognized at the communication date should be adjusted to the amount that would have been recognized if the revised provisions had been applied at and subsequent to the original communication date. The cumulative effect of the change shall be recognized as an adjustment to the recorded liability in the period of change, as discussed in the preceding paragraph.

Entities applying SFAS 146 should also consider SFAS 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Plans and for Termination Benefits. Entities terminating a significant number of employees who are participants in the entity’s defined benefit pension plan should consider whether a curtailment of that plan occurred. A curtailment includes the termination of a significant number of employees earlier than expected and requires special accounting applications to the entity’s defined benefit pension plan. In addition, SFAS 88 also applies to the recognition of certain incremental benefits provided to employees who voluntarily terminate their employment. This occurs when a plan of termination otherwise meeting the SFAS 146 criteria includes both involuntary termination benefits and additional termination benefits offered for a short period of time in exchange for employees’ voluntary termination of service. In these circumstances, the entity should recognize a liability for involuntary benefits pursuant to SFAS 146, and, when the employees accept the offer and the amount can reasonably be estimated, an additional liability for the incremental voluntary benefits pursuant to SFAS 88 (Exhibit 4).

Contract termination costs. A liability for costs to terminate a contract before the end of its term should be recognized and measured at fair value when the entity terminates the contract in accordance with its contract terms or ceases use of the rights conveyed by the contract (such as using leased property or receiving goods or services). Costs to terminate a contract are defined as either those costs to terminate the contract before the end of its term or those costs that will continue to be incurred without economic benefit for its remaining term. Changes in the estimated liability subsequent to the initial measurement date shall be accounted for in the same manner as for changes in estimated employee termination benefits. The time of recognition of contract termination costs under SFAS 146 differs from that in EITF 94-3, which requires recognition at the date the entity becomes committed to the exit or disposal plan.

Contract termination costs include those associated with the termination of operating leases. The fair value of the liability related to the termination of an operating lease is the present value (using a credit-adjusted risk-free interest rate) of the remaining lease rentals, minus the estimated sublease rentals that could reasonably be obtained for the property (Exhibit 5). FASB requires consideration of sublease rentals because, if an entity breaches a lease, the landlord may be legally required to mitigate his damages, even if the lease itself cannot be cancelled. The sublease rentals should be estimated even if the entity does not intend to enter into a sublease. Remaining lease rentals should not be reduced past zero.

In the periods subsequent to the initial measurement, the liability may be revised to reflect changes in the timing or amount of estimated cash flows. Changes to the liability are measured using the original credit-adjusted risk-free interest rate. The cumulative effect of changes due to revisions in the timing or amount of estimated cash flows is recognized, in the period the estimates were revised, as an adjustment to the liability and in the same line item in the income statement as when originally recognized. Changes due to the passage of time are recognized as an increase in the liability and as an accretion expense. As with employee termination benefits, the accretion expense is not considered an interest expense for financial reporting purposes. FASB does not require periodic evaluation of the liability, but does anticipate that liabilities associated with exit or disposal activities will be short-lived (Exhibit 6).

Liabilities for other costs associated with an exit or disposal activity, such as costs to consolidate or close facilities and relocate employees, are recognized when incurred.

Reporting and Disclosure

In reporting costs associated with an exit or disposal activity, the entity must first determine if the activity is a discontinued operation. SFAS 144 requires the results of operations of a component of an entity that has either been disposed of or held for sale to be reported as a discontinued operation if both the following conditions are met:

A component of an entity consists of operations and cash flows that can clearly be distinguished, both operationally and for financial reporting purposes, from the rest of the entity. Costs associated with an exit or disposal activity that involve a discontinued operation are included in the results of discontinued operations in the income statement. Costs associated with an exit or disposal activity that do not involve a discontinued operation are included in income from continuing operations before income taxes in the income statement.

If an event or circumstance occurs that discharges an entity’s responsibility to settle a liability for a cost associated with an exit or disposal activity recognized in a prior period, the liability is reversed through the same expense line item in the income statement as when originally recognized.

The following information should be disclosed in the notes to the financial statements for the period in which an exit or disposal activity is initiated (and any subsequent periods until the activity is completed):

Exhibit 7 presents a sample footnote of a restructuring disclosed in accordance with SFAS 146. As stated earlier, SFAS 146 applies to exit and disposal activities whose initiation date is after December 31, 2002, and EITF 94-3 applies to restructuring activities initiated prior to January 1, 2003. Thus, SFAS 146 does not require any transition disclosures for transactions initiated before, but completed after, the effective date.

SAB 103

SAB 103, “Codification of Staff Accounting Bulletins,” includes an update of the SEC’s previous guidance on restructuring costs contained in Topic 5P, “Restructuring Charges,” to reflect SFAS 146 and SFAS 144. SAB 103 deleted sections 1, “Characteristics of an Exit Plan,” and 2, “Characteristics of Exit Costs.” SAB 103 also revised section 3, “Income Statement Presentation of Restructuring Charges,” to reflect SFAS 144’s less restrictive definition of a discontinued operation. Section 3 explicitly requires that restructuring charges not related to the disposal of a separate component of the entity be presented in the income statement as a component of income from continuing operations. Exit and disposal charges cannot be presented as a component of “other income/expense” after income from continuing operations.

SAB 103 also updated section 4, “Disclosures,” to reflect the disclosure requirements of SFAS 146. Although section 4 did not significantly revise the disclosures required in the Management Discussion and Analysis (MD&A), it did reiterate the SEC’s view that the economic or other events which cause a company to consider or adopt an exit or disposal plan generally occur over time. Accordingly, the SEC expects the disclosure of these events in the MD&A in the periods prior to the recognition of exit and disposal costs. In the current climate, reporting companies should consider unfavorable trends, commitments, or uncertainties to determine whether they should be disclosed in their MD&A. This would avoid any SEC comments in future periods when exit and disposal costs are recognized.