The FASB's Emerging Issues Task Force has issued guidance in connection with the accounting for corporate restructurings. There are two basic issues - what costs should he classified as restructuring costs and when should these costs he recognized. Some of the answers may surprise you.

Corporate restructurings are reported in the financial press with notable frequency. Such restructurings are aimed at enhancing corporate America's competitive edge in an ever-expanding global market. These pervasive changes in the private sector have been in response to a variety of changes in the global economic environment including the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT).

The Securities and Exchange Commission (SEC) addressed the topic of restructuring as early as 1986 in Staff Accounting Bulletin No. 67, Income Statement Presentation of Restructuring Charges (SAB 67). While SABs are unofficial guidance reflecting the positions of the SEC's Chief Accountant and Division of Corporation Finance, registrants arc encouraged to adhere to their provisions. The requirements of SAB 67 call for the recognition and measurement of restructuring charges in the determination of income from continuing operations. Although entities were not permitted to remove restructuring charges from continuing operations, such costs could be reported as a separate line item within continuing operations. Additional discussion as to the related impact upon earnings per share (EPS) from restructuring activities was suggested as a part of the manage merit discussion and analysis (MD&A).

After a recent review of registrant filings, the SEC staff concluded that the number of restructurings has increased dramatically and the related financial reporting has varied widely in practice. The composition of corporate restructuring charges has been diverse, with a major component being employee-related costs (i.e., termination pay and other related benefits). The FASB's Emerging Issues Task Force (EITF) addressed the accounting and financial reporting of corporate restructuring in Issue 94-3, Liability Recognition for Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).

What Is a Corporate Restructuring?

In a restructuring, the corporation changes its business strategy or structure to improve future operations. Restructurings often include a plethora of items including the costs of employee severance and termination, costs to eliminate or curtail product lines, costs to consolidate or relocate operations, costs for new systems development or acquisition, losses relating to asset impairments, and losses on disposal of assets.

Corporations have frequently reported restructuring charges in the period in which the decision to restructure was made. Such practice was becoming increasingly widespread according to the EITF. The SEC found that restructuring charges at times included expenditures that would benefit future continuing operations, such as expenditures for equipment, costs associated with relocating and retraining employees, advertising and legal costs, charges for consulting services, and increased warranty liabilities on sales not yet made.

In accounting for a restructuring, the primary issues are the costs to be classified as restructuring and the timing of the recognition of these costs. While current GAAP provides some guidance in the recognition of restructuring charges, existing literature fails to provide a pathway for uniform practice. As stated in EITF 94-3, these issues provided the impetus for current discussions:

Although the accounting for some costs that have been included in restructuring charges, such as employee severance and termination costs, is addressed in existing accounting pronouncements, it is not always clear when those costs should be recognized if they arise in connection with a restructuring. The existing accounting pronouncements also do not address directly the accounting for other costs that may be incurred as part of a formally adopted restructuring plan, such as costs to consolidate or relocate plant facilities... Thus, it is not always clear whether those costs should be accrued in the period in which the restructuring plan is adopted or in a subsequent period. There appears to be diversity in practice in recognizing those costs.

The EITF differentiated between a disposal of a segment of a business and a restructuring. In a disposal, the plan focuses on one objective - the sale or abandonment of the segment. (The SEC issued SAB No. 93, Accounting and Disclosure Relating to Discontinued Operations, which provides registrants guidance for accruing and reporting costs of disposal.) Also, restructuring, in contrast, is likely to entail many different and separable objectives or actions. A restructuring plan may require a sequence of events to occur for completion. In addition, restructurings are often characterized by significant employee terminations that may not be the case in a disposal of a segment.

A restructuring may be considered complete when certain specific events have taken place including, for example, when all -

* planned employee terminations have occurred,

* operations identified for closure in the plan of restructuring have ceased,

* assets identified for sale have been disposed of, and

* exit costs have been paid.

Costs to Exit an Activity

The EITF reached conclusions on the issue of identifying costs that should be recognized as liabilities at the time management commits the entity to an exit plan. Costs to exit an activity (exit costs) should be recognized as a liability if 1) the commitment date has occurred, 2) such costs are true exit costs (i.e., no future benefit exists for such costs), and 3) the costs qualify for recognition at the commitment date.

Commitment Date Established. The measurement date for a discontinued operation in APB Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, provided the basis for the EITF's definition of the commitment date to exit an activity in a restructuring. The measurement date for the disposal of a segment of a business is defined as the date management commits to a formal plan to sell or otherwise dispose of the segment. As a minimum, the plan to dispose must include identification of the major assets to be disposed of, the expected method of disposal, the time expected to be required for completion of the disposal, an active program to find a buyer if the disposal is to be by sale, estimated results of operations of the segment from the measurement date to the disposal date, and estimated proceeds or salvage to be realized by disposal.

A commitment date for a restructuring is considered to occur when -

* prior to the date of the financial statements, management, having the appropriate level of authority, approves and commits the enterprise to a formal plan of restructuring;

* the plan of restructuring specifically identifies all actions to be taken to complete the plan of restructuring, operations that will not be continued - including the method of disposition and location of those operations, and the expected date of completion; and

* actions required by the exit plan are to begin as soon as possible after the commitment date and the period of time to complete the exit plan indicates that significant changes to the exit plan are not likely.

What Are True Exit Costs? Once a commitment date has been established, an assessment to determine if certain costs qualify for recognition in the current period is made. Such qualifying costs are considered exit costs. Only costs that do not benefit future operating activities may be considered exit costs. Exit costs are recognized in the period in which the commitment date occurs. Any costs that benefit future continuing operations should not be recorded as liabilities until an obligation exists to pay cash or to sacrifice assets. Exhibit 1 provides examples of costs that are not considered to be exit costs and, therefore, do not warrant liability recognition at the commitment date.

The EITF concluded that any anticipated operating losses relating to an activity that will not be continued are not exit costs and should be recognized as incurred. Furthermore, exit costs do not include costs relating to the disposal of assets. Under the provisions of EITF 94-3, costs necessary to sell assets are recognized in the current reporting period. This provision includes the costs of environmental contamination treatment required prior to the sale. Any expected gains from the sale should be recognized when realized and cannot be used to offset any liability for exit costs recognized at the commitment date.

Costs Qualifying for Recognition at Commitment Date. Exit costs may be considered for recognition as liabilities at the commitment date if they meet either criterion a) or b), and also meet criterion c) below:

a) The cost is incremental to other costs incurred by the enterprise in the conduct of its activities prior to the commitment date and will be incurred as a direct result of the exit plan. The notion of incremental does not contemplate a diminished future economic benefit to be derived from the cost but rather the absence of the cost in the enterprise's activities immediately prior to the commitment date.

b) The cost represents amounts to be incurred by the enterprise under a contractual obligation that existed prior to the commitment date, and the cost will either continue after the exit plan is completed with no economic benefit to the enterprise or be a penalty incurred by the enterprise to cancel the contractual obligation.

c) The cost is not associated with, or is not incurred to generate, revenues to be recognized after the exit plan's commitment date.

Only those exit costs that can be reasonably estimated warrant liability recognition at the commitment date. Any exit costs that cannot be reasonably estimated should not be recorded as liabilities until a reasonable estimate can be made.

For example, if an exit plan provides for the hiring of a systems consultant to develop and train employees to use new software applications, no liability will be recognized until the corporation is obligated to pay for the services. These costs would not be considered exit costs because ongoing operations will benefit. On the other hand, if the exit plan provides that the corporation retain an independent consulting firm to provide career and employment services to terminated employees, a liability would be recognized. These services to terminated employees would not benefit future operations and, therefore, would constitute an exit cost.

Exhibit 2 provides examples of costs considered to qualify as exit costs and warrant liability recognition at the commitment date.

Employee Termination Benefits

EITF 94-3 addresses liability recognition for costs involving involuntarily terminated employees. According to the EITF, corporations should recognize a liability for the cost of involuntary employee terminations in the period the restructuring plan is approved provided the following conditions are met:

* Prior to the date of the financial statements, management, having the appropriate level of authority to involuntarily terminate employees, approves, and commits the enterprise to the plan of termination and establishes the benefits current employees will receive upon termination.

* Prior to the date of the issuance of the financial statements, the benefit arrangement is communicated to employees. The communication of the benefit arrangement should include sufficient detail to enable employees to determine the benefits they will receive if they are terminated.

* The plan of termination specifically identities the number of employees to be terminated, their job classifications or functions, and their locations.

* The planned terminations will occur within one year from the date that management approves the plan of termination unless circumstances outside the control of the enterprise (e.g., legal or contractual restrictions that prevent the corporation from terminating employees) are likely to delay the termination date. Examples include existing union contracts or laws concerning the lead time for notifying employees before their termination.

EITF Issue 94-3 does not apply to involuntary employee terminations that are a) associated with a disposal of a segment and accounted for in accordance with APB Opinion 30, b) paid pursuant to the terms of a preexisting or newly created ongoing employee benefit plan, or c) paid under the terms of an individual deferred compensation contract.

Disclosure Requirements

Reporting entities should report the effects of recognizing a liability at the commitment date in income from continuing operations. The reporting should not be presented net of tax. The effects on earnings per share should not be presented on the face of the income statement. It is not permissible to combine revenues and related costs and expenses of activities not to be continued as a separate component of income.

If either the activities to be discontinued or the exit costs are material to the entity's overall operations, the following disclosures are required:

* A description of the major actions comprising the exit plan, activities that will not be continued, including the method of disposition, and the anticipated date of completion.

* A description of the type and amount of exit costs recognized as liabilities and the classification of those costs in the income statement.

* A description of the type and amount of exit costs paid and charged against the liability.

* The amount of any adjustment(s) to the liability.

* For all periods presented, the revenue and net operating income or losses from activities that will not be continued if those activities have separately identifiable operations.

SEC Enforcement Actions

The SEC Division of Enforcement has stated that restructuring charges are one of the areas carefully monitored in the filings of public registrants. The SEC has taken the position that the effects of a restructuring should be quantified in the period a plan is undertaken. In addition, material changes in the accrued balances of restructuring charges in subsequent periods should be disclosed in the financial statements and discussed in MD&A.

The SEC recently brought enforcement actions against Borden Inc. and Meris Laboratories for improper financial reporting of restructuring costs. The issues of these two recent enforcement cases highlight several SEC concerns.

Borden Inc. Borden agreed to reclassify or reverse $264 million of its original $642 million restructuring charges reported in 1992. A major portion of the reclassification was for marketing expenses. The reversals included adjustment of accruals for restructuring programs canceled after the 1992 restructuring plan. The SEC noted that operational costs should not be recorded as restructuring charges.

Meris Laboratories, Inc. The SEC found Meris understated expenses and overstated 1992 income by including future operating costs in the estimated purchase price of certain business acquisitions as part of a restructuring plan. The SEC argued that such costs should have been treated as recurring internal costs and, therefore, not capitalized. In addition, the Commission alleged that certain payroll costs of employees of the acquired company were improperly recognized as liabilities under the restructuring plan. Liability recognition was found to be unwarranted as the employees continued to provide services as part of Meris' continuing operations.

The Bottom Line

In effect, the EITF has taken the position that SFAS No. 5 rather than APB Opinion 30 provides the appropriate framework for recognition of liabilities in a restructuring plan. Since the consensus positions of the FASB EITF have a higher standing on the GAAP hierarchy of SAS No. 69, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report, than do AICPA accounting interpretations, the guidance on disposal of part of a line of business presented in the AICPA interpretation of APB opinion No. 30 may no longer be applied to restructurings.

This additional guidance of EITF 94-3 is designed to end the abuses where companies attempted to improve future results through aggressive accrual of costs. It will also result in better matching of revenues and expenses for reporting enterprises and more uniformity in financial reporting.

EXHIBIT 1

EMERGING ISSUES TASK FORCE (EITF) EXAMPLES OF COSTS THAT DO NOT QUALIFY AS EXIT COSTS

* An exit plan includes a change to distributed computer processing from mainframe computer processing that requires the purchase of new personal computers. The cost of purchasing the new personal computers is not an exit cost because the cost will benefit activities that will be continued.

* An exit plan includes a reduction in administrative personnel that requires costs (both internal and external) to develop software that will enable the remaining personnel to work more efficiently. Such costs are not exit costs because they benefit ongoing activities.

* An exit plan includes costs to hire outside consultants to identify future corporate goals, strategies, and necessary organizational structures. The costs of hiring the consultants for that project are not exit costs because of the culture benefits that will be derived.

* An exit plan includes an advertising program to promote a new company image. The cost of the advertising program is not an exit cost because the cost will benefit continuing activities.

* An exit plan includes costs to retrain and relocate existing employees. The employees will be part of the enterprise's ongoing activities and, therefore, cannot be considered exit costs.

* The cost of packing and moving inventory and equipment from a closed facility to another facility are not exit costs since such cost will benefit continuing operations.

* An enterprise will close a manufacturing plant as part of the exit plan. The plant will remain in operation for one year from the plan commitment date, after which all employees will be terminated. As a result of the exit plan, the enterprise expects to incur higher workers' compensation and health and welfare costs for employees involved in revenue-producing activities after the commitment date. The incremental increase in the workers' compensation and health and welfare costs related to claims for injuries and illnesses that arise after the commitment date are not exit costs since they are associated with generating revenues after the commitment date.

* The level of employee terminations associated with an exit plan is expected to result in prospectively higher premiums for unemployment insurance in future periods. The incremental increase in future premiums is not an exit cost because it is associated with ongoing activities.

* An exit plan includes plant consolidations that are expected to lead to higher costs related to customer service problems. As a result, customer deductions (sales allowances) on sales after the commitment date are expected to be higher as a percentage of sales than historical amounts. Such cost increases are not exit costs because they are associated with revenue generation.

* An exit plan includes a plant closure. The enterprise will operate the plant for one year from the commitment date to complete outstanding customer orders. Unfavorable overhead variances that will result from the fixed nature of certain manufacturing costs and the smaller number of units in production are not exit costs. Such costs are neither contractual obligations nor incremental to other costs incurred.

EXHIBIT 2

EMERGING ISSUES TASK FORCE (EITF) EXAMPLES OF COSTS TAHT QUALIFY AS EXIT COSTS

* An exit plan includes ceasing operations currently performed in a facility the enterprise leases under an operating lease. A lease- cancellation penalty fee the enterprise will pay to terminate the lease is an exit cost.

* An exit plan includes relocating operations currently performed in a leased facility to a site owned by the enterprise. The lessor will not release the enterprise from the lease agreement and will not permit the enterprise to sublease the facility. The enterprise does not intend to reopen the facility prior to the lease's expiration. The cost of the remaining noncancelable term of the operating lease after operations cease is an exit cost.

* An exit plan includes a reduction in the operations currently performed in a leased facility. The lease is an operating lease that expires three years from the commitment date, and the lessor will not permit the unused portion of the facility to be subleased. At the commitment date, the floor space of the leased facility is fully used in operations and will continue to be fully used for one year. When the exit plan is completed one year from the commitment date, only 70% of the leased space will be used. The remaining 30% of the facility will be permanently idle and is physically separate from the utilized space. The cost of the final two years of the lease attributable to 30% of the idle leased space is an exit cost.

* A plant will be closed and made permanently idle as part of an exit plan. The plant will operate for one year after the commitment date. After the plant ceases operations, all employees will be terminated except for a certain number of employees retained until work is completed to close the plant. Costs of employees (salaries and benefits) and other costs to be incurred after operations cease and that are associated with the closing of the plant are exit costs.

* A plant will be closed as part of the exit plan. The plant will remain in operation for one year after the exit plan commitment date after which all employees will be terminated. As a direct result of the exit plan, the enterprise expects to incur higher workers' compensation and health and welfare costs for employees that will be terminated. The incremental increase in the workers' compensation and health and welfare costs related to claims for injuries and illnesses prior to the commitment date and directly attributable to the exit plan is an exit cost.

* An exit plan includes a facility closure and exit from certain lines of business. The enterprise will continue to operate the facility for approximately one year after the commitment date to complete outstanding customer orders. The enterprise will subcontract all warranty work on products after the commitment date. The cost of subcontracting the warranty work exceeds the cost the enterprise would have incurred if the work had been performed as part of ongoing operations. The increase in cost for warranty work on products sold after the commitment date is an exit cost.

Robert W. Rouse, PhD, CPA, is a professor and Roger B. Daniels, PhD, CPA, an assistant professor at the College of Charleston. Thomas Weirich, PhD, CPA, is a professor at Central Michigan University.