July
7,
2006
Ms.
Linda
Cvrkel
Branch
Chief
Securities
and Exchange Commission
Division
of Corporate Finance
Washington,
D.C. 20549-0305
| RE: | Franklin Covey Co. (the Company) |
| Form 10-K for the year ended August 31, 2005 | |
| File No. 1-11107 | |
| Response to Commission Letter Dated June 26, 2006 |
Dear
Ms.
Cvrkel:
This
letter is written in response to the Staff's review of the Company’s Form 10-K
for the year ended August 31, 2005 as outlined in the Commission’s letter dated
June 26, 2006. As requested, the Company is providing the following supplemental
information and responses regarding our financial statements and disclosures
contained in our Form 10-K for the fiscal year ended August 31, 2005. The
Company’s third fiscal quarter ended on May 27, 2005 and the Company
incorporated revisions and additional disclosures as requested by this comment
letter in its quarterly report on Form 10-Q, as appropriate, which is due to
be
filed with the Commission on July 11, 2006.
Management’s
Discussion and Analysis
Liquidity
and Capital Resources
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1.
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In
future filings, please disclose the anticipated amount of capital
expenditures for the following fiscal year in your liquidity and
capital
resources section of MD&A. See Item 303(a)(2) of Regulation
S-K.
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Response:
The Company will include disclosure of anticipated capital expenditures in
its
future filings as requested and in compliance with Item 303(a)(2) of Regulation
S-K.
Consolidated
Financial Statements
Consolidated
Statements of Operations and Comprehensive Income (Loss)
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2.
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We
note from your disclosure in your MD&A section that the income tax
benefit for fiscal 2005 resulted primarily from the reversal of accruals
related to the resolution of certain tax matters. Please explain
to us
your accounting policy for recording income tax reserves. Tell us
the
nature of the facts and circumstances surrounding the reversal of
the
accruals and why you determined it was appropriate to reverse the
accruals
in fiscal 2005.
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Response:
The Company regularly evaluates United States federal and various state and
foreign jurisdiction income tax exposures. The tax benefits of tax exposure
items are not recognized in the provision for income taxes unless it is probable
that the benefits will be sustained, without regard to the likelihood of tax
examination. A tax exposure reserve represents the difference between the
recognition of benefits related to exposure items for income tax reporting
purposes and financial reporting purposes. The tax exposure reserve is
classified as a component of the current income taxes payable account. The
Company adds interest and penalties, if applicable, each period to the reserve
which is recorded as a component of the overall income tax
provision.
The
Company recognizes the benefits of the tax exposure items in the financial
statements, that is, the reserve is reversed, when it becomes probable that
the
tax position will be sustained. To assess the probability of sustaining a tax
position, the Company considers all available positive evidence. In many
instances, sufficient positive evidence will not be available until the
expiration of the statute of limitations for Internal Revenue Service audits,
at
which time the entire benefit will be recognized as a discrete item in the
applicable period.
During
fiscal 2005, the Company reversed a portion of its income tax reserves during
its 3rd
fiscal
quarter, primarily due to the expiration of the applicable statute of
limitations.
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3.
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We
note your presentation of the gain from the sale of an equity investment
as part of income from operations. In future filings, please present
this
gain as non-operating
income.
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Response:
The Company will reclassify the gain on the disposal of our investment in an
unconsolidated subsidiary to non-operating income as requested beginning with
our report on Form 10-Q for the quarter ended May 27, 2006. The Company recorded
the gain from the sale of the unconsolidated subsidiary in operating income
since the amount was considered a recovery of the previously impaired investment
that was recorded as an operating expense.
Notes
to the Financial Statements
Note
1. Nature of Operations and Summary of Significant Accounting
Policies
Revenue
Recognition
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4.
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We
note from your disclosure in MD&A that you recognize royalty income
from distributors. Please tell us, and disclose in the notes to the
financial statements in future filings, your accounting policy for
recognizing royalty income. Also, please tell us the amount of royalty
income that was recorded during fiscal 2004 and fiscal
2005.
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Response:
The Company’s international strategy includes the use of licensees in countries
where the Company does not have a directly-owned operation. Licensee companies
are unrelated entities that have been granted a license to translate the
Company’s content and curriculum, adapt the content and curriculum to the local
culture, and sell the Company’s training seminars and products in a specific
country or region. Licensees are required to pay royalties to the Company based
upon a percentage of the licensee’s sales. The Company recognizes royalty income
each period based upon the sales
information reported to the Company from the licensee. Royalty revenues totaled
$5.2 million in fiscal 2005 and $4.3 million in fiscal 2004. We will revise
future filings to disclose the policy for recognizing royalty income from
licensees in the notes to the financial statements.
Note
4. Property and Equipment
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5.
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We
note from your footnote that the difference between the carrying
value of
the financial obligation and the present value of the future minimum
financing obligation payments represent the carrying value of the
land
sold in the transaction, which is not depreciated and at the conclusion
of
the master lease agreement, the Company intends to write-off the
remaining
financing obligation and carrying value of the land. Please tell
us how
you considered the guidance under paragraph 26 of SFAS No. 13 in
determining the accounting treatment of the land and explain why
you
believe writing off the land is appropriate. Please provide us with
the
accounting guidance that supports your accounting
treatment.
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Response:
On June 21, 2005 the Company completed the sale of its corporate headquarters
facility located in Salt Lake City, Utah to an unrelated firm. In connection
with the transaction, the Company entered into a 20-year master lease agreement
with the purchaser. Because of the sale and leaseback nature of the transaction
and the inclusion of real estate, the Company primarily followed the guidance
found in SFAS No. 98, Accounting for Leases to account for the sale and
leaseback of its corporate campus.
Based
upon this guidance, the Company determined that the sale-leaseback transaction
did not qualify as a “normal leaseback” as defined in paragraph 8 of SFAS No. 98
because the Company is subleasing more than a minor portion of the
leased back property. According to paragraph 8 of SFAS No. 98, if the present
value of a reasonable amount of rental for that portion of the leaseback that
is
subleased is not more than 10 percent of the fair value of the asset sold,
the
leased back property under sublease is considered minor. The Company is
subleasing approximately 37 percent of the corporate campus that was sold and
leased back and the sublease activity did not qualify as minor as defined by
SFAS No. 98.
As
a
result of this determination and other characteristics of the transaction,
the
Company accounted for the sale and corresponding leaseback transaction as a
financing arrangement based upon the guidance found in paragraphs 34 and 35
of
SFAS No. 98 Appendix A. According to paragraph 34 of Appendix A, “the
seller-lessee reports the sales proceeds as a liability, continues to report
the
real estate or real estate and equipment as an asset, and continues to
depreciate the property.” The Company believes that under the terms of a
financing arrangement, the remaining asset and remaining lease obligation at
the
end of the master lease agreement should net to zero so there is no gain or
loss
to the Company at the end of the master lease agreement.
The
absence of significant definitive authoritative literature on financing
arrangements produces some uncertainty regarding the depreciation of existing
fixed assets since the concept of a financing arrangement seems to preclude
the
Company from recognizing a gain or loss from the transaction, unless the
conditions for sale accounting are subsequently met (e.g. the Company ceases
to
sublease more than a minor portion of the property). While paragraph 34 of
Appendix A prescribes that the Company should continue
to report the real estate and buildings sold as assets (representative of an
ongoing ownership interest in the assets), the underlying facts and
circumstances of the transaction indicate that the Company does not have any
remaining ownership interest, especially in the absence of ongoing continuing
involvement in the property, such as a guaranteed return to the buyer-lessor.
Accordingly, the Company believes that the ending salvage value of the buildings
and improvements and land should be equal to the carrying value of the land
(which does not depreciate) at the end of the master lease agreement. This
treatment is consistent with the economic substance of the transaction (i.e.
the
buildings, improvements, and land do not belong to the Company and will not
have
any fair value to the Company at the end of the lease term) and that accounting
for the sold buildings with a residual salvage value as though the Company
owned
them is inaccurate. The Company also believes that depreciating the buildings
and improvements to a zero basis at the end of the lease term results in less
distortion to the financial statements as the lease obligation will decline
more
closely to the actual underlying obligation to buyer-lessor. Due to the lack
of
continuing involvement, the Company believes that zero salvage value is also
more indicative of the actual value to the Company at the end of the master
lease agreement and is representative of the economic substance of the
transaction.
Due
to
the nature of the sale-leaseback transaction as described above, the Company
believes that the guidance found in SFAS No. 98 is more relevant to the
transaction than the guidance found in SFAS No. 13 paragraph 26 given that
the
transaction did not initially meet the criteria to be accounted for as a sale
transaction. The Company believes that it is inconsistent with SFAS No. 98
to
break out the land from the building given that the master lease is not
considered a lease for accounting purposes and is accounted for as a financing
obligation.
Note
11. Management Common Stock Loan Program
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6.
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We
note from your disclosure that based upon the changes made to the
terms of
the management common stock loan program, you currently account for
the
loans as variable stock option arrangements. Please explain to us
how you
consider the shares outstanding under the management loans in calculating
basic and diluted earnings per
share.
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Response:
During fiscal 2000, certain of the Company’s management personnel borrowed funds
from an external lender, on a full-recourse basis, to acquire shares of the
Company’s common stock. These shares were issued to management stock loan
participants and were considered owned (entitled to voting rights, common
dividends, etc.) and outstanding the same as other shares of outstanding common
stock. Following the issuance of common stock to management loan participants,
the shares were included in outstanding shares for purposes of calculating
basic
earnings per share (EPS).
As
a
result of the May 2004 modifications to the management stock loans, which are
disclosed in the Form 10-K for the year ended August 31, 2005, the loans were
determined to be non-recourse stock compensation instruments based upon guidance
found in EITF Issue 00-23 and EITF Issue 95-16. The Company believes that the
change in accounting from full-recourse notes receivable to non-recourse stock
option arrangements represented a recharacterization of the compensation model
and not a change in the nature of the outstanding shares associated with the
management common stock
loans. Therefore, the outstanding shares held by management common stock loan
participants continue to be included in the denominator for purposes of
calculating basic and diluted EPS.
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7.
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We
note that you currently account for your management stock loans as
variable stock arrangements, and under the adoption of SFAS No. 123R
you
will only recognize additional compensation expense if the Company
takes
action on the loans that in effect constitutes a modification of an
option. Please explain to us why it appears that your management
common
stock loans will not be marked to market at the end of each reporting
period upon adoption of SFAS No. 123R. Please tell us why you believe
your
accounting treatment is appropriate and provide us with the
accounting guidance that supports your treatment. We may have further
comment upon receipt of your
response.
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Response:
As a result of modifications made to the terms of management stock loans in
May
2004, the Company determined that the management stock loans should be accounted
for as non-recourse loans. Pursuant to footnote 2 of APB 25 and EITF 95-16,
the
combination of the non-recourse loans and the underlying shares issued are
in-substance stock options. Under EITF 95-16 the in-substance stock options
were
accounted for as variable stock option agreements, which would have required
the
Company to record additional compensation expense if the per share fair value
of
the Company’s common stock increased to an amount exceeding the per share value
of the outstanding loan balance plus accrued interest.
Under
the
new guidelines of SFAS No. 123R, share-based awards may be classified as either
liability awards or equity awards. The fair value of liability awards must
be
remeasured at the end of each reporting period through settlement, while the
fair value of equity awards is fixed at the grant date. The Company believes
that the management common stock loans are fully vested equity-classified
instruments, and not liability-classified awards that would be marked to market
at the end of each reporting period.
In
making
this determination, the Company considered the criteria for classifying awards
as liabilities, which are found in paragraphs 29 through 35 of SFAS No.
123R. These paragraphs also make specific reference to paragraphs 8 through
14
of SFAS No. 150. Based upon the guidance in these sources, the Company
considered the following factors in its determination of whether the management
common stock loans should be classified as equity awards or liability
awards.
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1.
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Repurchase
Features
-
Paragraph 31 of SFAS 123R addresses awards that provide a conditional
obligation to transfer assets; for example, shares that give the
employee
the right to require the Company to repurchase them for cash equal
to
their fair value (puttable award). The management stock loans contain
no
such put or call provisions that require a cash transfer or other
asset
transfer to repurchase the shares.
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Options
or similar instruments on shares shall be classified as liabilities if (a)
the
underlying shares are classified as liabilities or (b) the entity can be
required under any circumstances to settle the option or similar instrument
by
transferring cash or other assets. There
are
no circumstances that would require the Company to settle the management stock
loans with a cash payment to the participants (paragraph 32 of SFAS 123R) and
the underlying shares are classified as equity.
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2.
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Awards
with Conditions Other than Market, Performance, or Service
Conditions
-
If an equity award contains an additional award factor that is not
based
upon a market, performance, or service condition, the equity award
should
be classified as a liability (paragraph 33). The management stock
loans
are fully vested to the participants, the number of shares is fixed,
and
the loans do not contain additional award or vesting
conditions.
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3.
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Evaluation
of Management Common Stock Loan Terms in Determining Whether it Qualifies
as a Liability
-
Paragraph 34 of SFAS No. 123R directs that the accounting for a
share-based award shall reflect the substantive terms of the award
and any
related arrangement and indicates that the written terms of the award
provide the best evidence of the nature of the award. If a company’s past
practice has been to settle share based awards with cash payouts,
or if
the choice of cash payment rests with the loan participant, then
the award
can be determined to be a liability. The management stock loan program
does not have any terms that would indicate that the award has any
characteristics of a liability to the
Company.
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4.
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Broker
Assisted Cashless Exercises and Minimum Statutory Withholding Requirements
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According to paragraph 35 of SFAS No. 123R, a provision that permits
employees to effect a broker-assisted cashless exercise of part or
all of
an award of shares through a broker does not result in liability
classification for instruments that otherwise would be classified
as
equity if certain criteria exist. The Company does not believe that
this
condition is applicable to the management common stock loan
program.
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5.
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Certain
Obligations to Issue a Variable Number of Shares
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SFAS No. 150 paragraph 12 states that a financial instrument that
embodies
an unconditional obligation, or a financial instrument other than
an
outstanding share that embodies a conditional obligation, that the
issuer
must or may settle issuing a variable number of its equity shares
shall be
classified as a liability if, at inception, the monetary value of
the
obligation is based solely or predominantly on certain criteria.
The
shares have already been issued to loan program participants and
there is
no variability in the number shares to be issued or a requirement
for the
Company to issue additional shares to loan program
participants.
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Based
upon the foregoing guidance in SFAS No. 123R and SFAS No. 150, the Company
believes that the in-substance stock options defined by the combination of
the
management common stock loans and the underlying shares qualify as
equity-classified instruments and that additional compensation expense will
only
be recognized if the Company takes action that constitutes a modification which
increases the fair value of the option arrangements.
Other
Management
acknowledges that the Company is responsible for the adequacy and accuracy
of
the disclosure in the filings; Staff comments or changes to disclosure in
response to Staff comments in the filings reviewed by the Staff do not foreclose
the Commission from taking any action with respect to the filing; and that
it is
the position of the Staff that the Company may not assert Staff comments as
a
defense in any proceeding initiated by the Commission or any person under the
federal securities laws of the United States in connection with the Company’s
response to the Commission’s comments.
The
Company believes that the supplemental information presented above is fully
responsive to the Staff’s comments on our annual report on Form 10-K for the
fiscal year ended August 31, 2005. Please contact me with any further questions
that you may have regarding these matters.
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Sincerely,
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| /s/ STEPHEN D. YOUNG | |||
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Stephen
D. Young
Chief
Financial Officer
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