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					Inventory Write-Downs

    Cisco Systems Charge for
      Inventory Impairment
Inventory
   CSCO is but one of the companies that
    has recently taken a a substantial
    charge for write-down of inventory.
   What are some of the issues?
   Hilzenrath, Washington Post

   “Analysts Say April Write-Off May
    Flower: $2.5 Billion Inventory Charge
    Seen Helping Cisco Profit Picture”
   “On its face, it would seem like an
    unmitigated disaster. Cisco Systems,
    the leading maker of Internet
    equipment, announced this week that it
    is stuck with $2.5 billion of useless
    inventory that it expects to write-off in
    an accounting charge during the
    quarter that ends next Saturday.
   ...By declaring a mountain of parts and
    unfinished products worthless for
    accounting purposes, they said, Cisco
    could be setting itself up to book
    windfall profit in the future.
   That‟s because if the company ends up
    using the parts it is writing off, its cost
    of manufacturing products would be
    reduced, at least on paper.
   “They‟re going to get a future earnings
    boost form the reduced costs of
    inventory when they sell them, if they
    do sell them,” said Brad Rexroad of the
    Center for Financial Research &
    Analysis. If that happens, he said, “it‟s
    a fiction--it‟s not portraying the true
    economic reality of the business.”
   The write down was slightly less than
    the $2.6 billion CSCO reported during
    the previous quarter as COGS.
   Rexroad termed CSCO‟s planed
    inventory write-off “ridiculous” because
    of its size and because the surplus parts
    had been acquired within the past six
    months. But “it‟s up to management to
    decide what to write off, and you can
    pull a figure out of a hat,” he said.
   What does GAAP say? How should
    inventory be evaluated?
What does CSCO say?
From CSCO 10Q
   "The first four months of 2001 were
    extremely challenging as we went from
    year-over-year bookings in excess of
    70% in November, to 30% negative
    growth within a span of several months.
    This may be the fastest deceleration
    any company of our size has ever
    experienced," said John Chambers,
    president and CEO of Cisco Systems.
   "We believe that the challenges we face
    are primarily based on macro-economic
    and capital spending issues, although
    there is always room for improvement
    in our own operations. We believe the
    strong will get stronger while the
    economy rapidly goes through peaks
    and valleys of change.
   We recorded a provision for inventory,
    including purchase commitments,
    totaling $2.36 billion in the third quarter
    of fiscal 2001, of which $2.25 billion
    related to an additional excess
    inventory charge. Inventory purchases
    and commitments are based upon
    future sales forecasts.
   To mitigate the component supply
    constraints that have existed in the
    past, we built inventory levels for
    certain components with long lead
    times and entered into certain longer-
    term commitments for certain
    components.
   Due to the sudden and significant
    decrease in demand for our products,
    inventory levels exceeded our
    requirements based on current 12-
    month sales forecasts.
   This additional excess inventory charge
    was calculated based on the inventory
    levels in excess of 12-month demand
    for each specific product. We do not
    currently anticipate that the excess
    inventory subject to this provision will
    be used at a later date based on our
    current 12-month demand forecast.”
   What do you think? What were the
    issues facing CSCO?
   CSCO claims...”the company takes a
    very conservative approach to
    accounting across the board.” CSCO
    arrived at the write-off using “a process
    that we have used for years that has
    been reviewed by our auditors.” The
    company claims that the only change
    during the quarter in question was a
    “very significant” decline in demand.
   A CSCO executive agreed in the
    quarterly earnings conference call that
    the company‟s profit margin would
    benefit if it ever sells the parts in
    question. Chambers said, “Obviously, if
    we planned on doing that we wouldn‟t
    be writing them down at the present
    time.”
   Even after the write-off, CSCO
    maintained $1.16 billion of inventory.
   Executives also noted that sooner or
    later the parts will become obsolete and
    that many were custom made for
    CSCO.
   CSCO is hanging on to the surplus, “just
    in case”. “Physically, they will be put in
    a secured area and we will monitor
    demand going forward,” CFO Larry R.
    Carter said.
   But analyst Steve Kamman of CIBC
    World Markets questioned why the
    company would pay for warehouse
    space if it is truly without value.
    “Normally, when you have something
    written off, you store it in a landfill, not
    in a separate warehouse.”
   At the same time that CSCO took the
    inventory write-down, they also cut
    8,500 jobs and took a one-time charge
    of $300 - $400 million related to layoffs.
   CSCO also expected to take a charge of
    roughly $300 to $500 million related the
    consolidation of several facilities, and
    another charge of up to $300 million for
    the impairment of assets, primarily
    goodwill.
   So, should CSCO have “known” ?
   What would the impact be if CSCO had
    NOT written off inventory?
The SEC speaks...
   Lynn Turner on May 31, 2001, at the
    20th Annual SEC and Financial
    Reporting Conference at USC:
   ...Something we have read about in the
    press lately, and that is the inventory
    write-downs that have been recorded
    by some companies. These write-
    downs were both large in dollar amount
    and large in relation to the overall
    inventory balance.
Turner states that inventory write-downs
  of the magnitude that have been
  publicly reported raise a number of
  questions.
 Have the write-downs been taken on a

  timely basis?
   What changes in the business have
    occurred that resulted in the write-
    downs?
   Were complete and full disclosures
    made on a timely basis?
   What is the accountability of
    management for these write-downs?
    It is important to manage the supply
    chain from suppliers, through order
    management, production and
    manufacturing, on to shipping and right
    on through to inventory levels at
    customers or in the distribution
    channel.
   Did management identify on a timely
    basis increases in inventory levels
    at the customer or in other segments of
    the marketing channels?
   What steps were taken in the order
    management and manufacturing
    process to adjust purchases from
    suppliers?
   Were increases in inventory consistent
    with increases in bookings and
    sales?
   Were supply contracts flexible
    enough to permit changes to order
    quantities or were there take or pay
    contracts that had negative implications
    for inventory balances and purchases?
   Are inventories still on hand after any
    write-offs reasonable in light of
    existing backlog or are they still high in
    light of historical levels?
   Turner says, “I suspect the staff will
    focus on this issue. We certainly do not
    want another In-Process Research and
    Development issue.”
   SEC staff will also question
   What has been the status of the items
    reported on slow-moving items reports
    for the past three or four quarters?
   Have parts with no sales in the past few
    quarters been identified and
    properly accounted for on a timely
    basis?
   Do inventory write-downs take into
    consideration internal reports form
    marketing and sales with respect to
    forecasted sales?
   What information has been obtained or
    is available regarding inventory levels at
    customers or in the distribution
    channel?
   Have these sales reports been
    consistent with what has been reported
    to analysts and investors?
   When and how does the company plan
    on disposing of parts which have been
    completely written off or are considered
    obsolete?
   When and what communications have
    there been with suppliers regarding
    reductions in orders?
   Turner further notes that there is
    concern that companies might be taking
    write-downs now with the belief that
    they may be able to sell the same parts
    later on at a profit margin.
   Turner claims, “This is not what ARB 43
    intended. . . I believe write-offs of
    inventory for the purpose of later
    recognizing a profit margin on the sale
    of that item is contrary to GAAP, and
   anyone involved risks dealing directly
    with the Division of Enforcement as
    opposed to the Division of Corporation
    Finance of the Office of the Chief
    Accountant.”
   Turner also notes, “. . . Some
    companies are treating these inventory
    adjustments as „pro forma‟ adjustments
    as if they were not expenses. I do
    believe it is important to disclose
    changes in estimates of the carrying
    value of inventory.
   But at the same time, inventory being
    reduced in value was paid for by cash.
    It is a cash operating expense that has
    been incurred. . .

(but what about predicting FUTURE cash
  flows for inventory…)
   As a result, it would behoove investors
    and their representatives on the Board
    of Directors to ask the tough questions
    regarding what happened to the
    company‟s and the investor‟s cash”
   Again, what are the issues?
   Only one component is financial
    statements that “present fairly”. The
    other component is how investors and
    financial advisors USE the information
    that is reported.
   What about “pro forma” results that
    ignore these large charges (even if they
    are reconciled to GAAP under Reg G)?
   Again, there is a difference between
    evaluating stewardship and evaluating
    the nature, timing, and uncertainties of
    future cash flows.
   Stewardship is “looking backwards” to
    evaluate management and
    management decisions.
   (Of course, how management
    responded to challenges in the past
    may be a predictor of how well
    management might respond to
    challenges in the future…)
   Isn‟t an investment in inventory a sunk
    cost? How should sunk costs be
    treated when making future-oriented
    decisions?
   WHY???
Restructuring and Impairment
   SFAS 121 establishes the guidance for
    impairment of long-lived assets, certain
    identifiable intangibles and goodwill
    related to those assets
   SFAS 121 was issued in March 1999.
    Several implementation issues arose,
    and the Board has issued FAS 144,
    Accounting for the Impairment or
    Disposal of Long-Lived Assets. While
    this standard is based on the framework
    established in SFAS 121, it also
    addresses implementation issues.
   (What does this tell you about the
    difficulty in moving toward “principles-
    based” standards?)
   And because the treatment of Goodwill
    was considered in the new standard on
    accounting for Business Combination,
    Goodwill has been excluded from the
    new standard on Impairment.
What triggers an impairment
   A significant decrease in the market
    value of an asset
   A significant change in the extent or
    manner in which an asset is used
   A significant adverse change in legal
    factors or in the business climate that
    affects the value of an asset
   An accumulation of costs significantly in
    excess of the amount originally
    expected to acquire or construct an
    asset
   A projection or forecast that
    demonstrates continuing losses
    associated with an asset
   An expectation that a company will
    dispose of an asset significantly before
    the end of its useful life.
   Notice…the turnover at top
    management levels has NOT been
    suggested as a triggering event for
    an asset impairment.. (What does
    this have to do with Levitt‟s “Numbers
    Game” speech?)
Recoverability
   To address the question of possible
    asset impairment, a recoverability
    test is used.
   To evaluate impairment, one must first
    estimate the future net cash inflows
    expected from the use of the asset and
    its eventual disposition. This is the
    recoverable cost of the asset. There
    is a presumption that the recoverable
    cost is at least equal to the asset‟s book
    value. If not, the asset is impaired.
   If the sum of the expected future net
    cash flows (recoverable cost) is less
    than the carrying amount of the asset,
    the asset is impaired.
   Recoverable cost is not a present value.
    It is the nominal net sum of future cash
    inflows. The presumption behind a
    plant asset having a book value of
    $40,000 is that at least that much will
    be coming in over the remaining useful
    life of the asset…however long that
    useful life might be.
   How does this relate to our working
    definition of an asset?
   If the recoverability test indicates an
    asset impairment, the impairment loss
    is measured as the amount by which
    the carrying amount of the asset
    exceeds its fair value.
   The fair value of an asset is measured
    by its market value if an active market
    exists. Otherwise, the fair value of an
    asset is the present value of the
    expected future net cash flows,
    discounted at the appropriate market
    rate of interest.
   What about determining the existence
    of an impairment charge based on
    recoverable cost, while determining the
    amount of the charge as a function of
    fair values or discounted cash flows?
   The Board has provided some additional
    guidance on measuring fair value in the
    absence of an observable market price.
   The Board has decided to include in an
    appendix to the final Statement
    guidance on the use of present value
    techniques to estimate fair value in
    FASB CON 7, Using Cash Flow
    Information and Present Value in
    Accounting Measurements.
   The Board also plans to separately issue
    a communications piece on CON 7 that
    will provide additional discussion on the
    use of present value to estimate fair
    value.
   So CON 7 is already being used as a
    guide for developing new GAAP….we‟ll
    talk more about the strengths and
    weaknesses of using fair values in
    accounting next week.
   Recoverability is only used to test for
    impairment, not to measure the
    impairment loss.
   IF it is determined there is an
    impairment, then fair value is used to
    determine the amount of the loss.
   Fair value become the new basis for
    calculating depreciation.
   Impairments are often considered for a
    group of assets, rather than individual
    assets.
   (Why?)
   Companies must group long-lived
    assets with other assets and liabilities at
    the lowest level for which there are
    identifiable cash flows.
   When a company recognizes an
    impairment loss for an asset group, it
    must allocate the loss to the long-lived
    assets in the group on a pro rata basis
    using their relative carrying amounts.
    (There is an exception when the loss
    allocated to an individual asset reduces
    its carrying amount below fair value.)
   A business must include an impairment
    loss in the income from continuing
    operations before income taxes line on
    its income statement.
   What does this say about the FASB‟s
    views the impairment loss?
Why is this such a big issue?
   Remember, impairment and
    restructuring charges were among the
    issues raised by Levitt in “The Numbers
    Game”. The issue remains a focus of
    the SEC.
   And it is easy to see why. It is difficult
    to pick up the WSJ without seeing a
    story about a company restructuring its
    business or taking an impairment
    charge.
   Typically, events leading up to a
    restructuring charge or a loss in value
    of an asset, particularly a long-lived
    asset, whether tangible or intangible,
    do not occur overnight. Instead, the
    develop and evolve over a number of
    months or even years.
   When these events begin to occur, they
    require disclosure…if we recognize
    them...(hopefully on a timely basis)
   Remember the guidelines for
    recognizing these restructuring charges:
   Probable
   Estimable
   Related to an event that has already
    occurred.
   Again, what are the potential problems
    with restructuring charges?
   Related to an event that has already
    occurred…

   Evolved over time, or new decisions?
   Measurement…that ordinary expenses
    aren‟t hidden in with the restructuring
    charges.
   Does that mean restructuring charges
    shouldn‟t be taken?
   Would that be in compliance with
    GAAP?
   Remember our goal…FAIR
    PRESENTATION of financial information
    to aid in the determining the timing,
    nature, and uncertainty of future cash
    flows….
   The SEC is reviewing the adequacy of
    disclosure both for the period when an
    impairment is announced and also
    looking back at earlier filings.
   Also, the SEC will examine whether the
    cash flows and assumptions used to
    record restructuring charges and asset
    impairments are the same as those
    used in the company‟s budgets and
    strategic plans that have been provided
    to the Board of Directors by
    management...
   And the SEC has noted that a change in
    management is often correlated with a
    restructuring and impairment charge.
   Remember the incentives of
    management to “take a bath” and start
    with a “clean” balance sheet...
   The SEC Staff will question the timing
    and appropriateness of impairment
    charges recorded at the same time as a
    change in senior management.
   In particular, the staff will look to see if
    there are underlying changes in the
    business and its economics, when those
    changes occurred, and whether those
    changes have been appropriately
    disclosed in the MD&A on a timely
    basis
   So the SEC is may be challenging both
    the amount of an impairment charge
    and the timing of an impairment
    charge
   Lynn Turner stated in a speech on May
    18, 2001 entitled “The Times, They Are
    a Changing” at the 33rd Rocky
    Mountain Securities Conference...
   As with many accounting standards, a
    degree of subjectivity and judgment
    exists when recognizing impairment
    losses. While the staff has given
    management the benefit of the doubt
    with respect to its determination of loss
    timing and measurement,
   the staff has been wary of accounting
    that seems manipulative, assumptions
    that are not credible, and a lack of
    timely, complete and transparent
    disclosures of the events leading up to
    the impairment.

				
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