During the difficult economic climate of the early 1990s, many major corporations decided to restructure, or to downsize and refocus their operations. Corporate downsizing often entails the retraining, layoff, or termination of many employees, and the associated costs to the firms may be substantial. Corporations that refocus their operations may discontinue various lines of business, often at considerable losses, and the process of restructuring a firm may take several years.
Accounting for restructuring costs is a controversial issue in financial reporting because the dollar amounts are often material and require difficult estimates of costs to be incurred over several years in the future. Moreover, in many cases, the costs are related to actions that are planned by management in future periods, rather than being based on completed agreements or transactions. Some investors and analysts suggest that current accounting practices in reporting restructuring costs give managers too much discretion in shaping the numbers that will appear on the present and future income statements. Case study 7 shows footnote disclosures of restructuring charges reported by a major corporation.
Case Study 7
The fiscal 1997 annual report of Rockwell International Company, a global electronics firm, included a footnote containing the following explanation of the effects of restructuring costs on the firm’s financial statements:
During 1996, the Company recorded restructuring charges of $76 million ($47 million after-tax, or 22 cents per share). The restructuring charges relate to a decision to exit non-strategic product lines of continuing operations as well as the costs associated with staff reductions in the Automation and Avionics & Communications businesses.
The provision includes asset impairments of $51 million, severance and other employee costs of $9 million, and contractual commitments and other costs of $16 million. These actions were substantially completed by the end of 1997.
a. Why do firms accrue restructuring costs before such costs are actually incurred? Do such costs satisfy the definition of liabilities that was presented in Chapter, “The Balance Sheet”?
b. Based on the footnote information, Rockwell has recognized restructuring costs of $76 million in 1996 and no significant additional charges in 1997. How will these charges affect the amounts of income reported by the firm in future years? How would these charges influence your comparison of the firm’s profit trend between 1996 and 1997?
a. Firms accrue restructuring costs because it has become apparent to management that the related assets have become less beneficial to the firm. Conservatism in financial accounting requires that such impairments in value be recognized currently. Because the decision to restructure operations is made in the current period, all the estimated associated expenses are recognized in the current period. It can be argued that such costs meet the definition of current liabilities because (1) the firm is presently obliged to make the future transfers, (2) the obligation is unavoidable, and (3) the event causing the liability has already occurred.
b. Because these costs have already been recognized as expenses by Rockwell in 1996, they will not result in expenses in future periods. Income in future years will be higher as a result. The income reported in 1996 is lower by the after-tax amount of the restructuring costs recorded in that year, and income reported in 1997 and subsequent years will be higher. Analysts may find it useful to adjust the reported income numbers to reflect earnings before the impact of the restructuring charges is taken into account.