Restructuring Charges – Background Information
To facilitate analysis, income statements prescribed by U.S. GAAP generally separate income into recurring and non-recurring components and companies are valued according to the changes in and sustainability of earnings with greater weight given to income that is expected to persist. One of these non-recurring components that has been the subject of attention is special items with the most common type being restructuring charges. Using a sample of firms from the Compustat Annual Industrial files Fairfield et al. (2009) document that the percentage of firms reporting income decreasing special items has steadily increased during the 1984 to 2003 period from 12% to over 45%.
Restructuring charges are reported as a component of income from continuing operations and generally associated with significant retrenchment strategies which decrease income and take the form of employee severance packages, asset write-offs, contract (operating) lease buy-outs, etc. Enacted in 2003, SFAS 146 (FASB 2003) provides guidance on the reporting and disclosure of these costs. In general, companies are required to estimate and report (expense) all prospective restructuring costs along with a corresponding liability in the year of implementation. Actual costs are written off against the liability in the year costs are realized. Since costs are aggregated and reported in the year of commitment, restructuring charges are typically significant. For example, in their most recent quarter (2nd quarter, 2013), IBM reported a 1 billion dollar restructuring charge which reduced quarterly earnings per share to $2.91, down 13% from a year ago. The charge involves a targeted reduction in the company’s workforce (http://online.wsj.com/article/SB10001424127887323993804578612151153367448.html?mod=europe_home).
In light of the purported transitory nature of restructuring costs, their value relevance relative to other recurring expenses should be less and prior studies document that when valuing companies, analysts assign lower weights to these costs (Bradshaw and Sloan 2002). Extant research provides evidence that these charges have become a significant earnings management tool as managers move prior and / or future period recurring operating expenses into the current restructuring commitment period and report them as transitory thereby increasing future and / or past earnings. In a recent comprehensive academic study, Cain et al. (2013) use a methodology that separates special items into low and high quality and document that one third of special items are actually recurring and low-quality special items predict restatements. The separate reporting of transitory items is currently under consideration by the joint FASB/IFRS financial statement project. Currently, GAAP requires special items to be reported as a component of income from continuing operations while IFRS does not separate unusual or infrequent (special) items from operating expenses.
For many students, there may be an assumption that bottom line net income unequivocally depicts the financial performance of the firm when in fact net income may be better perceived as a construct whose magnitude is derived largely from accruals estimates made by managers across a wide spectrum of operating activities. While these estimates are intended to foster a more credible and timely earnings measure, their inherent uncertainty along with the discretion accorded managers who may have incentives to distort these estimates can have an adverse impact on earnings quality. In light of their increasing use the consideration of restructuring charges from both a financial reporting and valuation perspective is an important topic for accounting and finance students.
Restructuring Charges – Facts (Human Resources Plus)
The following case requires analysis from both an accounting and financial statement analysis perspective. Using information from FASB as provided in its Accounting Standards Codification and supporting literature, student’s record journal entries for costs associated with a service firm’s restructuring initiative. Then using alternative scenarios pertaining to the quality of these charges, students are required to analyze their valuation impact.
HRP (Human Resources Plus) is a publicly held employee leasing firm that services small to mid-size companies. Due to increasing competition, HRP has continued to lose market share in its northeast region. Based on a recent 2012 analysis of its operations, HRP management has announced it will cease operations in the northeast and close its sole office there in 2013. HRP’s fiscal year ends on December 31. The company leases the land and building on which the northeast headquarters office is located. The term of the lease is 10 years with 7 years remaining. Annual lease payments are $100,000 and payable each year on January 1. The lease contract includes an early termination provision that stipulates in the event of early termination, the lessee shall pay the lessor an amount equal to an additional two year’s rent over and above any amount paid for the current year. HRP will terminate its lease on July 1 of 2013. As a result of the closure, HRP announces on December 1, 2012, that effective March 1, 2013 it will terminate 200 employees and provide a one-time severance payout of $15,000 per employee. The severance payments will occur within two weeks after termination. To provide as much flexibility as possible to their current employees, there is no requirement that the affected employees remain with HRP until the termination date. In other words, employees will receive their severance payments whether or not they remain during the December to March period.
HRP has 5,000,000 shares of common outstanding. Diluted earnings per share before restructuring charges for 2012 are $1.00 and are expected to continue forever (an annuity in perpetuity). HRP does not pay a dividend. Other than the above restructuring charges all other expenses may be characterized as normal and reoccurring.
Case Two: Restructuring Charges – Requirements
Based on the information provided in this case and using the information provided in The FASB Accounting Standards Codification and including SFAS 146, please provide the appropriate summary journal entries and note disclosure for the implementation year (2012) and the following year (2013) when HRP’s charges are realized. Using information from the FASB Accounting Standards Codification, please include your rationale for reporting to both the appropriate accounts and their amounts.
2. Financial Statement Analysis
a. What effect will the restructuring costs have on HRP’s 2012, current and quick ratios. What effect will it have on ROA?
b. Using a the discounted value of the company’s earnings and assuming a cost of capital (discount rate) of 10%, what is your end of year 2012 estimate of the value of the company today under each of the following valuation methods (since this analysis assumes that the firm will continue as a going concern for the foreseeable future you may ignore the effect of book value on your estimate):
(1). The 2012 restructuring charge is treated as a one time (non-recurring) expense;
(2). The restructuring charge is ignored;
(3). Twenty percent of the employee severance packages would have occurred without the restructuring initiative and are in fact recurring operating expenses.
Please provide a written explanation for the differences in value.
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