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.