Auto World Inc Essay

Auto World Inc. (AWI) is a leading automotive retail and service chain. They have many operating segments comprised of two different centers 10 miles apart from each other. Pit Stop Centers (PSC) offer service labor, installed merchandise, and tires while their Auto Boyz Centers (ABC) sells automotive merchandise. AWI has a plan to close their operating segment PSC to change their current operating structure to improve and efficiently deliver retail products and automotive services by providing their customers with a ‘one stop’ shopping for ‘do-it-yourself’ retail customers and ‘do-it-for-me’ customers† (PSC Case). AWI expects this change to enhance their ability to increase market share, improve sales, and company earnings. This change in restructuring will have an effect on current earnings and will need to be reported properly in their 2007 Income Statement. AWI must report this continuing activity properly under US Generally Accepted Accounting Principles (GAAP). The FASB Accounting Standards Codification (ASC), commonly known as GAAP has specific standards that must be followed in order to classify the disposal of an entity as discontinued or continues operation of a component of an entity. Under the guidance of numerous ASC’s, AWI does not meet the two conditions to report their PSC closures as discontinued operations. The criteria used, assessment period, presentation, and disclosure for this retail company will be explained in detail when applying proper GAAP. A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity; it may be a reportable segment or an operating segment, a reporting unit, a subsidiary, or an asset group in which Auto World determined correctly under the first requirement that the PSC met the definition of a â€Å"component of an entity† (ASC 205-20-20). The two conditions for reporting the disposed transaction as discontinued operations are: The results of operations of a component of an entity that either has been disposed of or is classified as held for sale under the requirements of paragraph 360-10-45-9, shall be reported in discontinued operations in accordance with paragraph 205-20-45-3 if both of the following conditions are met: 1. The operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction. 2. The entity will not have any significant continuing involvement in the operations of the component after the disposal transaction (ASC 205-20-45-1). Several steps below will be used to explain why the disposal of the PSC stores should be considered a continuation of operations rather than discontinue of operations (ASC 205-20-55-3). These three steps along with their respective answers are also depicted in a flow chart (see Appendix A). Step one asks are continuing cash flows expected to be generated by the ongoing entity? Yes, the continuing cash flows are being generated by ABC from transactions with customers from PSC. Step two asks if the continuing cash flows result from a migration or continuation of activities. The continuing cash flows are the result of a migration from the closed PSC’s to the â€Å"one stop† ABC. ABC sells products similar to those sold in the closed retail stores. After the closure of the Pit Stop Centers, Auto World estimates that there will be continuing cash flows from the sale of automotive services and tires by the ongoing ABC’s of approximately $600 million. Auto World estimates that the Pit Stop Centers would have generated approximately $700 million of sales absent the disposal transaction (PSC Case). Step three asks if the continuing cash flows are significant. Yes, the ongoing ABC estimates the continuing cash inflows will approximate 86 percent (see Appendix B) of that would have been generated by PSC’s absent the disposal transaction. AWI is expecting these actions to generate significant cash flow in 2007 and to increase free cash flow in 2008. AWI is also expecting to yield improvements in operating earnings of approximately $58 million in 2008 to be significant leading to the classification as a discontinued operation to be inappropriate (ASC 205-20-55-70). Since stakeholders rely on financial statements to base their decisions and to project future cash flows, current information presented must be accurate under GAAP Under the second requirement, one issue I have identified is the intentions of management’s decisions to improve their company’s net earnings. The professional literature I relied on are these two statements, â€Å"the actions we are announcing today will further enhance our ability to increase market share and improve sales and earnings at our company† and â€Å"in this regard, we remain committed to the automotive business and we expect to deliver significant additional profitable growth† were made by Mr. Bobby, chairman and chief executive officer. When considering the use and disclosure of restructuring charges, depending on the industry, there should not be re-occurring â€Å"restructuring cost† line item on the Income Statement year after year. Closing the PSC stores as of the second quarter in June 2007 is an event taking place in 2007 which can happen only once. If management continues to show this type of special/unusual charge in future periods, the question of integrity should be raised. Management does not want to give off the impression of possibly smoothing earnings by using restructuring charges. â€Å"Once a decision to restructure is made, GAAP requires companies to estimate the future costs they expect to incur to carry out the restructuring for such things as plant closings (AWI currently estimates it will incur restructuring and other charges totaling $52 million pre-tax). These estimated restructuring costs are then charged to an expense account with an offsetting credit to a liability account (Restructuring reserve) in the current period† (Revsine, pg 155). In developing my recommendation and conclusion for resolving this issue, management should make a foot note explaining these changes which will allow stakeholders to make better decisions. The new re-structured ABC will continue to sell automotive parts that were previously sold through the PSC’s, and under the ASC, PSC store closures are not considered and cannot be reported as a discontinued operation in AWI’s second quarter financial statements. The continuing cash flows are being generated by ABC from transactions with customers from PSC, given by the level of significance of 86 percent for this continuing cash flow subsequent to the disposal transaction.