O'Reilly Auto Parts 2007 Annual Report Download - page 21

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• Taxes – We operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues,
which may require an extended period of time to resolve. We regularly review our potential tax liabilities for tax years subject to audit. The amount
of such liabilities is based on various factors, such as differing interpretations of tax regulations by the responsible tax authority, experience with
previous tax audits and applicable tax law rulings. Changes in our tax liability may occur in the future as our assessments change based on the
progress of tax examinations in various jurisdictions and/or changes in tax regulations. In management’s opinion, adequate provisions for income
taxes have been made for all years presented. The estimates of our potential tax liabilities contain uncertainties because management must use
judgment to estimate the exposures associated with our various tax positions and actual results could differ from our estimates. Alternatively, we
could have applied assumptions regarding the eventual outcome of the resolution of open tax positions that would differ from our current estimates
but that would still be reasonable given the nature of a particular position. Our judgment regarding the most likely outcome of uncertain tax
positions has historically resulted in an estimate of our tax liability that is greater than actual results. While our estimates are subject to the
uncertainty noted in the preceding discussion, our initial estimates of our potential tax liabilities have historically not been materially different
from actual results except in instances where we have reversed liabilities that were recorded for periods that were subsequently closed with the
applicable taxing authority.
The accounting for our tax reserves changed with the adoption of Financial Accounting Standards Board ("FASB") Interpretation No. 48,
"Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48") on January 1, 2007. Refer to Note 1
for further discussion of the impact of adopting FIN 48 and change in reserves during Fiscal 2007.
• Share-based compensation – Prior to January 1, 2006, we accounted for share-based compensation plans under the provisions of
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”), as permitted under Statement of Financial
Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123.
Effective January 1, 2006, we adopted SFAS No. 123R, “Share Based Payment,” under the modified prospective method. Accordingly, prior
period amounts have not been restated. Under this application, we record share-based compensation expense for all awards granted on or after
the date of adoption and for the portion of previously granted awards that remain unvested at the date of adoption. Currently, our share-based
compensation relates to stock option awards, employee share purchase plan discounts, restricted stock awards and shares contributed directly to
other employee benefit plans.
Under SFAS No. 123R, we use a Black-Scholes option-pricing model to determine the fair value of stock options. The Black-Scholes model
includes various assumptions, including the expected life of stock options, the expected volatility and the expected risk-free interest rate. These
assumptions reflect our best estimates, but they involve inherent uncertainties based on market conditions generally outside our control. Since
our adoption of SFAS No. 123R, share-based compensation cost would not have been materially impacted by the variability in the range of
reasonable assumptions we could have applied to value option award grants, but we anticipate that share-based compensation cost could be
materially impacted by the application of alternate assumptions in future periods. Also, under SFAS No. 123R, we are required to record share-based
compensation expense net of estimated forfeitures. Our forfeiture rate assumption used in determining share-based compensation expense is estimated
based on historical data. The actual forfeiture rate and corresponding share-based compensation expense could differ from those estimates.
• Inventory Obsolescence and Shrink – Inventory, which consists of automotive hard parts, maintenance items, accessories and tools is
stated at the lower of cost or market. The extended nature of the life cycle of our products is such that the risk of obsolescence of our inventory
is minimal. The products that we sell generally have application in our markets for a relatively long period of time in conjunction with the
corresponding vehicle population. We have developed sophisticated systems for monitoring the life cycle of a given product and, accordingly,
have historically been very successful in adjusting the volume of our inventory in conjunction with a decrease in demand. We do record a reserve
to reduce the carrying value of our inventory through a charge to cost of sales in the isolated instances where we believe that the market value of
a product line is lower than our recorded cost. This reserve is based on our assumptions about the marketability of our existing inventory and is
subject to uncertainty to the extent that we must estimate, at a given point in time, the market value of inventory that will be sold in future
periods. Ultimately, our projections could differ from actual results and could result in a material impact to our stated inventory balances. We
have historically not had to materially adjust our obsolescence reserves due to the factors discussed above and do not anticipate that we will
experience material changes in our estimates in the future.
We also record a reserve to reduce the carrying value of our perpetual inventory to account for quantities in our perpetual records above the
actual existing quantities on hand caused by unrecorded shrink. We estimate this reserve based on the results of our extensive and frequent cycle
counting programs and periodic, full physical inventories at our stores and distribution centers. To the extent that our estimates do not accurately
reflect the actual inventory shrinkage, we could potentially experience a material impact to our inventory balances. We have historically been able
to provide a timely and accurate measurement of shrink and have not experienced material adjustments to our estimates. If unrecorded shrink at
December 31, 2007 were double the estimate that we recorded based on our historical experience, the financial impact would have been less than
$3 million or less than 1.0% of pretax income.
Management’s Discussion and Analysis
of Financial Condition and Results of Operations (continued)