Restructuring

(Part of the earnings management bag of tricks)

Overview

• What is restructuring?

• Why can (did/does) it cause financial reporting problems?

• The SEC becomes involved

• Relevant accounting literature

• Restructuring was/is

Restructuring Activities

• In the 1980’s and 90’s the term “Restructuring” became one of the major buzzwords, also known as

• “getting lean and mean”

• Purpose: to improve efficiency, restore international competitiveness, pay for leveraged buy-outs

Restructuring consists of all or some of the following:

• Closing plants

• laying off employees

• moving operations

• reorganization of operations (very popular)

• cost cutting, cost cutting, cost cutting

Why can (did/does) it cause financial reporting problems?

• Restructuring is perceived to be good

• All costs even remotely (or sometimes not at all) associated with restructuring were reported as a separate line item (net of tax) on the income statement – (making it look like an extraordinary event)

• In some cases “restructuring” occurred year after year

Restructuring in Practice

Annual Sales

$19748

Annual Net Income

$882

4th Q 1993 Charge

$1,800

GTE Communications - Telecommunications

($ in Millions)

“Re-Engineering Plan” - 3 Years

• Termination benefits - 17,000 workforce reduction

•Consolidation of facilities

•Upgrading/replacing customer service and admin. Systems

•Enhance network software

•Training

Restructuring in Practice

Annual Sales

$7,142

Annual Net Income

$(439)

3th Q 1993 Charge

$642

Borden - Food and Non-Consumer Products

($ in Millions)

Charge includes costs to:

• Unify businesses

• Modernize and integrate product presentation

• Remedy problems in under performing businesses and reduce costs

Restructuring in Practice

Annual Sales

$9,622

Annual Net Income

$(495)

3th Q 1993 Charge

$775

Woolworth - Merchandise Stores

($ in Millions)

Charge includes costs of:

• Termination benefits - 13,000 workforce reduction

• Redesign or close stores

• Asset and inventory write downs

• Leases and occupancy costs

Restructuring in Practice

Annual Sales

$3,970

Annual Net Income

$(1720)

3th Q 1993 Charge

$225

Flagstar Companies, Inc. - Food Services Enterprises

($ in Millions)

Charge includes costs of:

• Termination benefits

• Closure of facilities

• Relocation and training

• Systems development costs

SEC Reactions

• 1993 - Problem identified: – One-line presentations, net of tax

• Solution: – SAB 67:

• Include charges in continuing operations

• No net-of-tax presentation

– Warning and comment letters– Mandatory restatements

SEC Warning Letters:“SEC wants explanation from firms planning

to post restructuring losses” (WSJ, 2/25/94)

Sent to 84 registrants that announced restructurings

• “Reminder” of specific 10K requirements: – Footnotes

• Circumstances; material elements;

• asset write-offs vs future cash outflows

– MD&A

• Current an expected effects

• future progress and changes

Restatements Mandated by SEC

• Examples:

– Borden– Flagstar– Woolworth

Restructuring Restatements

“Borden to Reverse, Reclassify 40% of 1992 Charge”

• Reversed $119 million

• Canceled projects

• Promotion accruals

• Reclassified $145 million as marketing expense

•Borden spokesman: “Truly incremental and related to one-time advertising and promotional program not occurring in the normal course of business

Restructuring Restatements

Flagstar Cos. Restated 1993 Financial Results

• Reduced reserve by $33 million

• Training

• Systems development

•Future costs to improve image

• Costs to be taken as incurred (normal operating expenses)

Restructuring Restatements

Woolworth Restated 1993 Quarterly Results

• Reduced repositioning reserve by $217 million

• Inventory markdowns

• Other normal operating costs

Relevant Accounting Standards

• Employee Termination Benefits:– FAS 112; 43; 5; and 88

• Other restructuring costs:– APB 30; FAS 5– EITF 94-3

FASB Statement 112: Tests

Rights arise from service?

Rights vest or accumulate?

Payment probable?

Payment estimable?

Yes to all No to any

Accrue over employee service life

Apply Statement 5, Accrue upon loss event

FASB Statement 88

•Special termination benefits

•employee accepts

•Contractual termination benefits

EITF 94-3

•Only costs to exit existing activities

•Involuntary employee termination benefits only if they are not under pre-existing or ongoing plan

•Relocation costs

EITF 94-3

•Provisions only appropriate for costs that:

•are not associated with future revenue generations and have no future economic benefits

•I.e., cannot include items such as advertising, training or system development

•Have an incremental cost of obligation that existed prior to consummation date

EITF 94-3/Purchase Accounting

•Criteria for Recognition:

•Consummation date - beginning to assess and formulate restructuring plan

•Plan is finalized - one year

•Plan is specific

•Period of time to complete plan indicates significant changes are not likely

•(this is to ensure that so-called “restructuring” will not be a regular, annual event)

EITF 94-3/Purchase Accounting

•Required Disclosures:

•Major actions

•Type and amount of exit costs accrued

• Type and amount of exit cost charged to accrual

•Adjustments

•If exit plan is not finalized

•Description of unresolved issues and types of potential liabilities

Restructuring Was

0102030405060708090

Net Income

1 2 3 4 5 6

Fiscal Quarter

Restructuring Is

0102030405060708090

Net Income

1 2 3 4 5 6

Fiscal Quarter

Restructuring Was/Is

0102030405060708090

Net Income

1 2 3 4 5 6

Fiscal Quarter

Restructuring Was Restructuring Is