SIGNIFICANT ACCOUNTING POLICIES
Valvoline’s significant accounting policies, which conform to U.S. GAAP and are applied on a consistent basis in all years presented, except as indicated, are described below.
Use of estimates, risks and uncertainties
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosures of contingent assets and liabilities. Significant items that are subject to such estimates and assumptions include, but are not limited to, long-lived assets (including goodwill), sales deductions, employee benefit obligations and income taxes. Although management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, actual results could differ significantly from the estimates under different assumptions or conditions.
Cash and cash equivalents
All short-term, highly liquid investments having original maturities of three months or less are considered to be cash equivalents.
Accounts receivable and allowance for doubtful accounts
Valvoline records an allowance for doubtful accounts as a best estimate of the amount of probable credit losses for accounts receivable. Valvoline estimates the allowance for doubtful accounts based on a variety of factors, including the length of time receivables are past due, the financial health of its customers, macroeconomic conditions, past transaction history with the customer and changes in customer payment terms. If the financial condition of its customers deteriorates or other circumstances occur that result in an impairment of customers’ ability to make payments, the Company records additional allowances as needed. The Company writes off uncollectible trade accounts receivable against the allowance for doubtful accounts when collections efforts have been exhausted and/or any legal action taken by the Company has concluded.
Inventories are carried at the lower of cost or market value. Inventories are primarily stated at cost using the weighted-average cost method. Cost includes materials, labor and manufacturing overhead related to the purchase and production of inventories. In addition, certain lubricants are valued at cost using the last-in, first-out (“LIFO”) method. The Company regularly reviews inventory quantities on hand and the estimated utility of inventory. Excess and obsolete reserves are established based on forecasted usage, product demand and life cycle, as well as utility.
Property, plant and equipment
The cost of property, plant and equipment is depreciated by the straight-line method over the estimated useful lives of the assets. Buildings are depreciated principally over 5 to 35 years and machinery and equipment principally over 5 to 15 years. Property, plant and equipment is relieved of the cost and related accumulated depreciation when assets are disposed of or otherwise retired. Gains or losses on the dispositions of property, plant and equipment are included in the Consolidated Statements of Comprehensive Income. Property, plant and equipment carrying values are evaluated for recoverability when impairment indicators are present and are conducted at the lowest identifiable level of cash flows. Such indicators could include, among other factors, operating losses, unused capacity, market value declines and technological obsolescence. Recorded values of asset groups of property, plant and equipment that are not expected to be recovered through undiscounted future net cash flows are written down to current fair value, which generally is determined from estimated discounted future net cash flows (assets held for use) or net realizable value (assets held for sale).
The financial results of the businesses that Valvoline has acquired are included in the Company’s consolidated financial results based on the respective dates of the acquisitions. The Company allocates the purchase consideration to the identifiable assets acquired and liabilities assumed in the business combination based on their acquisition-date fair values. The excess of the purchase consideration over the amounts assigned to the identifiable assets and liabilities is recognized as goodwill. Factors giving rise to goodwill generally include synergies that are anticipated as a result of the business combination, including access to new customers and markets. The fair values of identifiable intangible assets acquired in business combinations are generally determined using an income approach, requiring financial forecasts and estimates as well as market participant assumptions.
Goodwill and other intangible assets
Valvoline tests goodwill for impairment annually as of July 1 or when events and circumstances indicate an impairment may have occurred. This annual assessment consists of Valvoline determining each reporting unit’s current fair value compared to its current carrying value. Valvoline’s reporting units are Core North America, Quick Lubes, and International.
In evaluating goodwill for impairment, Valvoline has the option to first perform a qualitative assessment to determine whether further impairment testing is necessary or to perform a quantitative assessment by comparing the fair value of a reporting unit to its carrying amount, including goodwill. Under the qualitative assessment, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount. Qualitative factors include macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, among others.
If under the quantitative assessment, the fair value of a reporting unit is less than its carrying amount, then the amount of the impairment loss, if any, must be measured under step two of the impairment analysis. In step two of the analysis, an impairment loss will be recorded equal to the excess of the carrying value of the reporting unit’s goodwill over its implied fair value. Fair values of the reporting units are estimated using a weighted methodology considering the output from both the income and market approaches. The income approach incorporates the use of a discounted cash flow (“DCF”) analysis. A number of significant assumptions and estimates are involved in the application of the DCF model to forecast operating cash flows, including markets and market shares, sales volumes and prices, costs to produce, tax rates, capital spending, discount rate, weighted average cost of capital, terminal values and working capital changes. Several of these assumptions vary among reporting units. The cash flow forecasts are generally based on approved strategic operating plans. The market approach is performed using the Guideline Public Companies method which is based on earnings multiple data. The Company also performs a reconciliation between market capitalization and the estimate of the aggregate fair value of the reporting units, including consideration of a control premium.
Valvoline elected to perform a qualitative assessment during the fiscal 2017 and determined that it is not more likely than not that the fair values of Valvoline's reporting units are less than carrying amounts. In fiscal 2016, a quantitative assessment indicated that each reporting unit had a fair value that exceeded book value by 300% and more.
Acquired finite-lived intangible assets principally consist of certain trademarks and trade names, intellectual property, and customer relationships. Intangible assets acquired in an asset acquisition are carried at cost, less accumulated amortization. For intangible assets acquired in a business combination, the estimated fair values of the assets acquired are used to establish the carrying value, which is determined using common techniques, and the Company employs assumptions developed using the perspective of a market participant. These intangible assets are amortized on a straight-line basis over their estimated useful lives. Valvoline reviews finite-lived intangible assets for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable and any not expected to be recovered through undiscounted future net cash flows and assets are written down to current fair value.
Equity method investments
Investments in companies, including joint ventures, where Valvoline has the ability to exert significant influence, but not control, over operating and financial policies of the investee are accounted for under the equity method of accounting. As of September 30, 2017 and 2016, Valvoline’s investments in these unconsolidated affiliates were $30 million and $26 million, respectively. Judgment regarding the level of influence over each investment includes considering key factors such as the Company’s ownership interest, representation on the board of directors, and participation in policy-making decisions. The Company’s proportionate share of the net income or loss of these companies is included in the Consolidated Statements of Comprehensive Income.
The Company evaluates equity method investments for impairment whenever events or changes in circumstances indicate that the carrying amount of the investment might not be recoverable. Factors considered by the Company when reviewing an equity method investment for impairment include the length of time and extent to which the fair value of the equity method investment has been less than cost, the investee’s financial condition and near-term prospects, and the intent and ability to hold the investment for a period of time sufficient to allow for anticipated recovery. An impairment that is other-than-temporary is recognized in the period identified.
Pension and other postretirement benefit plans
Prior to the Contribution in fiscal 2016, Valvoline employees were eligible to participate in pension and other postretirement benefit plans sponsored by Ashland in many of the countries where the Company does business. Prior to the Contribution, the Company accounted for its participation in Ashland-sponsored pension and other postretirement benefit plans as a participation in a multiemployer plan, and recognized its allocated portion of net periodic benefit cost based on Valvoline-specific plan participants. In conjunction with the Contribution, certain of Ashland's pension and other postretirement benefit obligations and plan assets were transferred to and assumed by the Company, for which Valvoline accounts for as single-employer plans prospectively from the Contribution in late fiscal 2016. As single-employer plans, Valvoline recognizes the net liabilities and the full amount of any costs or gains. Valvoline also had certain international single-employer pension plans prior to the Contribution for which the net liabilities and associated costs have been recognized in the historical periods.
The majority of U.S. pension plans have been closed to new participants since January 1, 2011 and effective September 30, 2016, the accrual of pension benefits for participants were frozen. In addition, most foreign pension plans are closed to new participants while those that remain open relate to areas where local laws require plans to operate within the applicable country. In addition, Valvoline sponsors healthcare and life insurance plans for certain qualifying retired or disabled employees. During March 2016, these other postretirement benefit plans were amended to reduce retiree life and medical benefits effective October 1, 2016 and January 1, 2017, respectively.
The funded status of Valvoline’s pension and other postretirement benefit plans is recognized in the Consolidated Balance Sheets. The funded status is measured as the difference between the fair value of plan assets and the benefit obligation at September 30, the measurement date, and whenever a remeasurement is triggered. The fair value of plan assets represents the current market value of assets held by irrevocable trust funds for the sole benefit of participants. For defined benefit pension plans, the benefit obligation is the projected benefit obligation (“PBO”) and for other postretirement benefit plans, the benefit obligation is the accumulated postretirement benefit obligation (“APBO”). The PBO represents the actuarial present value of benefits expected to be paid upon retirement based on estimated future compensation levels. The APBO represents the actuarial present value of other postretirement benefits attributed to employee services already rendered. The measurement of the benefit obligations is based on estimates and actuarial valuations. These valuations reflect the terms of the plans and use participant-specific information such as compensation, age and years of service, as well as certain key assumptions that require significant judgment, including, but not limited to, estimates of discount rates, expected return on plan assets, rate of compensation increases, interest rates and mortality rates.
Valvoline recognizes the change in the fair value of plan assets and net actuarial gains and losses annually in the fourth quarter of each fiscal year and whenever a plan is determined to qualify for a remeasurement. Such gains and losses may be related to actual results that differ from assumptions as well as changes in assumptions, which may occur each year. The remaining components of pension and other postretirement benefits expense are recorded ratably on a quarterly basis. The service cost component of pension and other postretirement benefits costs is allocated to each reportable segment on a ratable basis, while the remaining non-service and remeasurement components of pension and other postretirement benefits costs are excluded from segment results and included in Unallocated and other as those items are not included in the evaluation of segment performance.
Commitments and contingencies
Liabilities for loss contingencies arising from claims, assessments, litigation, fines, penalties and other sources are recorded when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Legal costs such as outside counsel fees and expenses are charged to expense in the period incurred and are recorded in Selling, general and administrative expense in the Consolidated Statements of Comprehensive Income.
Valvoline partially insures its workers’ compensation claims and other general business insurance needs. Prior to the IPO, Ashland charged Valvoline for the applicable portion of costs. As part of the Contribution, Valvoline was transferred certain active and legacy Ashland insurance reserves. Valvoline records accrued liabilities related to these costs based upon specific claims filed and loss development factors, which contemplate a number of factors including claims history and expected trends. These loss development factors are developed in consultation with external actuaries.
Sales generally are recognized when persuasive evidence of an arrangement exists, products are delivered or services are provided to customers, the sales price is fixed or determinable and collectability is reasonably assured. Valvoline reports all sales net of tax assessed by qualifying governmental authorities. Certain shipping and handling costs paid by the customer are recorded in sales, while those costs paid by Valvoline are recorded in cost of sales.
Sales rebates and discounts, consisting primarily of promotional rebates and customer pricing discounts, are offered through various programs to customers. Sales are recorded net of these rebates and discounts totaling $360 million, $388 million and $345 million in the Consolidated Statements of Comprehensive Income for the years ended September 30, 2017, 2016 and 2015, respectively. Sales rebates and discounts are recognized as incurred, generally at the time of the sale, or over the term of the sales contract. Valvoline bases its estimates on historical rates of customer discounts and rebates as well as the specific identification of discounts and rebates expected to be realized.
Franchise revenue is also included within sales and was $28 million, $25 million, and $22 million during 2017, 2016, and 2015, respectively. Franchise revenue generally consists of initial franchise fees and royalties. Initial franchise fees are recognized when all material obligations have been substantially performed and the store has opened for business. Franchise royalties are based upon a percentage of monthly sales of the franchisees and are recognized in the month such sales occur.
Cost of sales include material and production costs, as well as the costs of inbound and outbound freight, purchasing and receiving, inspection, warehousing, internal transfers and all other distribution network costs. Selling, general and administrative expenses are expensed as incurred and include sales and marketing costs, advertising, customer support, environmental remediation, and administrative costs, including allocated corporate charges from Ashland for periods prior to the IPO. Advertising costs ($61 million in 2017, $58 million in 2016 and $56 million in 2015) and research and development costs ($13 million in each 2017 and 2016, and $11 million in 2015) are expensed as incurred.
For the periods prior to the Distribution, share-based awards for key Valvoline employees and directors were principally settled in Ashland common stock and expense was allocated to Valvoline based on the awards and terms previously granted. In connection with the Distribution, outstanding Ashland share-based awards held by Valvoline employees were converted to equivalent share-based awards of Valvoline. Stock-based compensation expense is generally recognized based on the grant date fair value of new or modified awards over the requisite vesting period. The Company’s outstanding stock-based compensation awards are primarily classified as equity, with certain liability-classified awards based on award terms and conditions. Valvoline accounts for forfeitures when they occur and recognizes stock-based compensation expense within the Selling, general and administrative expense caption of the Consolidated Statements of Comprehensive Income.
For the periods prior to Distribution, Valvoline’s operating results are included in Ashland’s consolidated U.S., state, and certain Ashland international subsidiaries' income tax returns. For these periods, the income tax provision in these Consolidated Statements of Comprehensive Income has been calculated as if Valvoline was operating on a stand-alone basis and filed separate tax returns in the jurisdictions in which it operates.
Income tax expense is provided based on income before income taxes. Deferred income taxes reflect the impact of temporary differences between assets and liabilities recognized for financial reporting purposes and such amounts recognized for tax purposes. These deferred taxes are determined based on the enacted tax rates expected to apply in the periods in which the deferred assets or liabilities are expected to be settled or realized. Valvoline records valuation allowances related to its deferred income tax assets when it is more likely than not that some portion or all of the deferred income tax assets will not be realized.
The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position are measured based on the largest benefit that has a greater than fifty percent likelihood of being sustained upon examination by authorities. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law and until such time that the related tax benefits are recognized.
Valvoline's derivative instruments consist of foreign currency exchange contracts, which are accounted for as either assets or liabilities in the Consolidated Balance Sheets at fair value and the resulting gains or losses are recognized as adjustments to earnings. Valvoline does not currently have any derivative instruments that are designated and qualify as hedging instruments.
Fair value measurements
Fair value is defined as an exit price, representing an amount that would be received to sell an asset or the amount paid to transfer a liability in an orderly transaction between market participants at the measurement date. As such, fair value is a market-based measurement determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the guidance prioritizes the inputs used to measure fair value into the three-tier fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). An instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement.
Except for pension plan assets, which are reviewed on annual basis, the Company reviews the fair value hierarchy classification on a quarterly basis. Changes to the observability of valuation inputs may result in a reclassification of levels for certain securities within the fair value hierarchy. Valvoline measures its financial assets and financial liabilities at fair value based on one or more of the following three valuation techniques:
Market approach: Prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities.
Cost approach: Amount that would be required to replace the service capacity of an asset (replacement cost).
Income approach: Techniques to convert future amounts to a single present amount based upon market expectations (including present value techniques, option pricing and excess earnings models).
The Company generally uses a market approach, when practicable, in valuing financial instruments. In certain instances, when observable market data is lacking, the Company uses valuation techniques consistent with the income approach whereby future cash flows are converted to a single discounted amount. The Company uses multiple sources of pricing as well as trading and other market data in its process of reporting fair values. The fair values of cash and cash equivalents, trade receivables and accounts payable approximate their carrying values due to the relatively short-term nature of the instruments.
Foreign currency translation
Operations outside the United States are measured primarily using the local currency as the functional currency. Upon consolidation, the results of operations of the subsidiaries and affiliates whose functional currency is other than the U.S. dollar are translated into U.S. dollars at the average exchange rates for the year while assets and liabilities are translated at year-end exchange rates. Adjustments to translate assets and liabilities into U.S. dollars are recorded in the stockholders’ equity section of the Consolidated Balance Sheets as a component of accumulated other comprehensive loss and are included in net earnings only upon sale or substantial liquidation of the underlying foreign subsidiary or affiliated company.
Earnings per share
Basic EPS is calculated by dividing net income by the weighted-average number of shares outstanding during the reported period. The calculation of diluted EPS is similar to basic EPS, except that the weighted-average number of shares outstanding includes the additional dilution from potential common stock such as stock-based compensation awards. Refer to Note 17 for information regarding a revision to correct an immaterial error in the net EPS calculations previously reported in the consolidated and condensed consolidated financial statements for the periods prior to and including September 30, 2016. While there were no shares of common stock outstanding prior to Valvoline’s IPO, the weighted average number of shares outstanding in these historical periods are based on the 170 million shares of common stock issued to Ashland.
New accounting pronouncements
Accounting Standards Updates Recently Adopted
In April 2015, the Financial Accounting Standards Board (the “FASB”) issued accounting guidance to help entities evaluate the accounting for fees paid by a customer in a cloud computing arrangement. Cloud computing arrangements represent the delivery of hosted services over the internet which includes software, platforms, infrastructure and other hosting arrangements. Under the guidance, customers that gain access to software in a cloud computing arrangement account for the software as internal-use software only if the arrangement includes a software license. Valvoline adopted this standard on a prospective basis on October 1, 2016, and as a result, certain costs related to these arrangements will be expensed when incurred. The adoption of this guidance did not have a material impact on the Company's financial condition, results of operations or cash flows.
In May 2015, the FASB issued accounting guidance which removed the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. Valvoline adopted this standard on October 1, 2016. Accordingly, certain investments that were measured using the net asset value per share practical expedient have not been categorized within the fair value hierarchy tables and have been separately disclosed. This guidance does not impact the valuation or recognition of these investments, and relevant disclosure amendments have been retrospectively applied to all periods presented in the Notes to Consolidated Financial Statements. Refer to Note 14 for additional information.
In March 2016, the FASB issued new accounting guidance for certain aspects of share-based payments to employees, which includes multiple provisions intended to simplify various aspects of the accounting for share-based payments. In particular, the tax effects of all stock-based compensation awards will be included in income, windfall tax benefits and deficiencies will be reported as discrete items in the interim period when they arise, all tax-related cash flows from share-based payments will be reported as operating activities in the statement of cash flows, the classification of awards as liabilities or equity due to tax withholdings may change, and accounting for forfeitures may change. This guidance is effective for the Company beginning October 1, 2017; however, Valvoline elected to early adopt this guidance in the quarter ended June 30, 2017, with all relevant adjustments applied as of the beginning of the fiscal year. This guidance also allows entities to make an accounting policy election to either estimate the number of awards that are expected to vest or account for forfeitures when they occur. The Company has elected to recognize forfeitures as they occur rather than estimate a forfeiture rate. The impact on Valvoline's consolidated financial statements as a result of adopting this new guidance was not material.
Accounting Standards Updates Issued But Not Yet Effective
In May 2014, the FASB issued accounting guidance outlining a single comprehensive five step model for entities to use in accounting
for revenue arising from contracts with customers (ASC 606, Revenue from Contracts with Customers). The new guidance supersedes
most current revenue recognition guidance, in an effort to converge the revenue recognition principles within U.S. GAAP. This new
guidance also requires entities to disclose certain quantitative and qualitative information regarding the nature, amount, timing and
uncertainty of qualifying revenue and cash flows arising from contracts with customers. Entities have the option of using a full
retrospective or a modified retrospective approach to adopt the new guidance. This guidance becomes effective for Valvoline on
October 1, 2018. Valvoline is in the process of evaluating its revenue streams, as well as the available implementation options, and cannot currently estimate the financial statement impact of adoption, though certain reclassifications are expected to be required in presentation of the Consolidated Statements of Comprehensive Income. The Company expects to complete its implementation assessment in early 2018 and will provide updated disclosures of the anticipated impact of adoption in future filings.
In July 2015, the FASB issued accounting guidance to simplify the subsequent measurement of certain inventories by replacing the
current lower of cost or market test with a lower of cost and net realizable value test. The guidance applies only to inventories for
which cost is determined by methods other than LIFO and the retail inventory method. This guidance became effective
prospectively for Valvoline on October 1, 2017. Valvoline utilizes LIFO to value approximately 72% of its gross inventory and does not expect there to be material differences in the Company's current valuation methodology for its remaining inventory using lower of cost or market to net realizable value.
In February 2016, the FASB issued new accounting guidance related to lease transactions. The primary objective of this guidance is to
increase transparency and comparability among organizations by requiring lessees to recognize assets and liabilities on the balance
sheet for the rights and obligations created by leases and to disclose key information about leasing arrangements. The presentation of
the Consolidated Statements of Comprehensive Income and the Consolidated Statements of Cash Flows is largely unchanged under
this guidance. This guidance retains a distinction between finance leases and operating leases, and the classification criteria for
distinguishing between finance leases and operating leases are substantially similar to the classification criteria for distinguishing
between capital leases and operating leases in the current accounting literature. The guidance will become effective for Valvoline on
October 1, 2019. Valvoline is currently evaluating the impact this guidance will have on Valvoline’s consolidated financial statements and developing specific assessment and implementation plans. The Company currently expects that most of its operating lease commitments will be subject to the new standard and recognized as operating lease liabilities and right-of-use assets upon adoption. Thus, the Company expects adoption will result in a material increase to the assets and liabilities on the Consolidated Balance Sheets.
In January 2017, the FASB issued accounting guidance which simplifies the subsequent measurement of goodwill by eliminating the second step of the two-step impairment test under which the implied fair value of goodwill is determined as if the reporting unit were being acquired in a business combination. The guidance instead requires entities to compare the fair value of a reporting unit with its carrying amount and recognize an impairment charge for any amount by which the carrying amount exceeds the reporting unit’s fair value. This guidance must be applied prospectively and will become effective for Valvoline on October 1, 2020, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. Valvoline's annual evaluation of goodwill for impairment is performed as of July 1. As this guidance simplifies the process for measuring impairment, management does not expect there will be an impact on the consolidated financial statements given the Company's historical excess fair value of its reporting units.
In March 2017, the FASB issued accounting guidance that will change how employers who sponsor defined benefit pension and/or postretirement benefit plans present the net periodic benefit cost in the Consolidated Statements of Comprehensive Income. This guidance requires employers to present the service cost component of net periodic benefit cost in the same caption within the Consolidated Statements of Comprehensive Income as other employee compensation costs from services rendered during the period. All other components of the net periodic benefit cost will be presented separately outside of the operating income caption. This guidance must be applied retrospectively and will become effective for Valvoline on October 1, 2018, with early adoption being optional. Valvoline adopted this guidance on October 1, 2017, which will have a significant impact on the presentation of the Consolidated Statements of Comprehensive Income as it will result in a reclassification of current and historical Pension and other postretirement plan non-service income and remeasurement adjustments, net from within operating income to non-operating income beginning with the Quarterly Report on Form 10-Q that will be filed for the first fiscal quarter of 2018.
The FASB issued other accounting guidance during the period that is not currently applicable or expected to have a material impact on Valvoline's financial statements, and therefore, is not described above.