Nature of Business and Significant Accounting Policies

12 Months Ended

Dec. 31, 2011

Nature of Business and Significant Accounting Policies

Nature of Business and Significant Accounting Policies

1. Nature of Business and Significant Accounting Policies

• Nature of Business

        Guitar Center Holdings, Inc., is the parent company of wholly-owned Guitar Center, Inc., and its wholly-owned subsidiaries. All of the company's operating activities are conducted out of Guitar Center, Inc., and its subsidiaries. The parent company's business activities consist solely of debt and equity financing related to its acquisition of Guitar Center, Inc., in 2007.

        In these notes, we refer to the consolidated financial statements of Guitar Center Holdings, Inc., and its subsidiaries as "Holdings," except where the context requires otherwise when discussing the debt or equity of the Guitar Center Holdings, Inc., entity. We refer to the consolidated financial statements of Guitar Center, Inc., and its subsidiaries as "Guitar Center." The terms "we," "us," "our" and "the company" refer to Holdings and Guitar Center collectively.

        Guitar Center is the leading United States retailer of guitars, amplifiers, percussion instruments, keyboards and pro-audio and recording equipment. As of December 31, 2011, Guitar Center operated 224 Guitar Center stores across the United States, with 146 primary format stores, 74 secondary format stores and four tertiary format stores, along with the www.guitarcenter.com website.

        Music & Arts specializes in band and orchestra instruments for sale and rental, serving students, teachers, band directors and college professors. As of December 31, 2011, Music & Arts operated 102 stores in 19 states, along with the www.musicarts.com website.

        Our direct response segment is a leading direct response retailer of musical instruments in the United States, and its operations include the Musician's Friend and other branded websites and catalogs.

• Principles of Consolidation

        The accompanying consolidated financial statements of Holdings and Guitar Center include the accounts of the respective companies' wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

• Use of Estimates in the Preparation of Financial Statements

        The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.

        We base our estimates on historical experience and on other assumptions that we believe to be relevant under the circumstances. In particular, we make judgments in areas such as allowances for doubtful accounts, depreciation and amortization, inventory valuation, self-insurance reserves, impairment of long-lived assets, goodwill and other intangible assets, litigation, provision for sales returns, vendor allowances, stock-based compensation and income taxes. Actual results could differ from these estimates.

        As a result of economic conditions in the United States, there is uncertainty about unemployment, consumer confidence and business and consumer spending. Over the last several years, these factors reduce our visibility into long-term trends, dampen our expectations of future business performance and can affect our estimates.

• Cash and Cash Equivalents

        Cash consists of cash on hand and bank deposits. Cash equivalents generally consist of highly liquid investments with an original maturity of three months or less. We had no cash equivalents as of December 31, 2011 or 2010.

• Accounts Receivable

        We grant credit directly to certain customers in the ordinary course of business. Prior to granting credit, we conduct a credit analysis based on financial and other criteria and generally do not require collateral.

        We record accounts receivable net of an allowance for doubtful accounts. We maintain allowances for doubtful accounts for estimated losses from the failure of our customers to make their required payments. We base our allowance on an analysis of the aging of accounts receivable at the date of the financial statements, an assessment of historical collection trends and an evaluation of the impact of current economic conditions.

• Merchandise Inventories

        We generally value inventories at the lower of the weighted average cost method or market value. We capitalize to inventory the costs associated with bringing inventory through our Guitar Center distribution center, and then expense these amounts to cost of goods sold as the associated inventory is sold.

        We value rental inventories and used and vintage guitars at the lower of cost or market using the specific identification method. We depreciate rental inventories on a straight-line basis while out under the rental agreement for rent-to-own sales.

        We receive price protection credits and rebates from our vendors, which we account for as a component of merchandise inventory and record at the time the credit or rebate is earned. We typically receive rebates on a quarterly or annual basis. We do not believe we have significant risk related to rebates receivable, based upon historically low write-offs, our long-standing relationships with a consistent pool of rebate vendors and our ability to net unpaid rebates against vendor account payables. We recognize the effect of price protection credits and vendor rebates in the income statement as a reduction in cost of goods sold at the time the related item of inventory is sold. We do not record any of these credits as revenue.

• Property and Equipment

        We record property and equipment at cost. We compute depreciation using the straight-line method over the estimated useful lives of the assets, generally five years for furniture and fixtures, computer equipment and vehicles, and 15 years for buildings. We amortize leasehold improvements over the shorter of their estimated useful lives or the terms of the related leases. We expense maintenance and repair costs as they are incurred, while renewals and betterments are capitalized.

        Our corporate aircraft, which was sold during 2011, was depreciated over 10 years with a 50% salvage value.

        Property and equipment are classified as held for sale when a plan of sale has been initiated, the property is being actively marketed for sale, the property is available for immediate sale and a completed sale is expected within 12 months. Property and equipment held for sale are carried at fair value, net of estimated selling costs, and are not depreciated. When we commit to a plan to sell an asset or asset group, we revise our depreciation estimates to reflect the assets' shortened useful lives for the period they will be held and used.

• Impairment and Disposal of Long-lived Assets

        We evaluate long-lived assets, such as property and equipment and amortizing intangible assets, for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to future undiscounted net cash flows expected to be generated by the asset group. If those assets are considered to be impaired, the impairment charge recognized is the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs.

        Asset groups for our retail businesses generally are comprised of retail store locations. The asset group for our internet and catalog operations includes the fulfillment center, customer contact center, amortizing intangible assets of our internet and catalog businesses and goodwill of our direct response reporting unit. Our entity-level asset groups generally consist of retail distribution centers, corporate headquarters facilities and data centers.

        Impairment charges related to tangible long-lived assets are included in selling, general and administrative expenses in the accompanying consolidated statements of operations. See Note 11 for further discussion of impairment of long-lived assets.

• Goodwill and Other Intangible Assets

        Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in business acquisitions. Goodwill and certain intangible assets with indefinite lives are not amortized but are subject to an annual impairment test. Our policy is to test for goodwill and indefinite-lived intangible asset impairment annually at the beginning of the fourth quarter and all intangible assets, including goodwill, whenever events and circumstances indicate that there may be an impairment of the asset value. Intangible assets with finite lives are amortized over their expected useful life and reviewed for impairment in the same manner as long-lived assets.

        We test for goodwill impairment at the reporting unit level. A reporting unit is an operating segment, or a business unit one level below that operating segment, for which discrete financial information is prepared and regularly reviewed by management. Our operating segments and reporting units are the same, consisting of Guitar Center, direct response and Music & Arts.

        Beginning in 2011, we adopted new accounting standards related to goodwill impairment testing. Under the revised accounting standards, our process for evaluating goodwill for impairment is as follows:

• •

  We first perform a qualitative assessment annually on October 1 at each reporting unit that has goodwill to determine if facts and circumstances indicate that goodwill is more likely than not impaired. If the qualitative assessment indicates that goodwill of a reporting unit is not more likely than not impaired, we do not perform a quantitative impairment test for the reporting unit. If the qualitative assessment indicates that goodwill of a reporting unit is more likely than not impaired, we perform the first step, or step 1, of the quantitative goodwill impairment test.

  •

  In step 1, we compare the carrying amounts of the affected reporting units to their estimated fair values. In determining the estimated fair values of the reporting units, we use market multiple and discounted cash flow analyses. If the carrying amounts of the reporting units exceed their estimated fair values, we perform the second step, or step 2, of the goodwill impairment test.

  •

  In step 2, we determine the implied fair value of goodwill at the affected reporting unit by allocating the reporting unit's estimated fair value to all the assets and liabilities of the applicable reporting unit (including any unrecognized intangible assets and related deferred taxes) as if the reporting unit had been acquired in a business combination. An impairment charge is recognized for the amount by which the carrying amount of goodwill exceeds its implied fair value.

  •

  We also test goodwill for impairment upon the occurrence of certain events or substantive changes in circumstances.

        In 2010 and 2009, we tested goodwill for impairment annually on October 1 by performing step 1 of the goodwill impairment test and performing step 2 if the carrying amount of a reporting unit exceeded its estimated fair value. We would also test goodwill for impairment upon the occurrence of certain events or substantive changes in circumstances, but no such events occurred during those periods.

        Significant management judgment is required in the qualitative assessment, specifically with respect to macroeconomic conditions, industry and market conditions such as competition and the regulatory environment and entity-specific events that can affect the estimated fair value of a reporting unit.

        Significant management judgment is required in the forecasts of future operating results that are used in both undiscounted and discounted impairment tests. We use estimates and assumptions that we consider reasonable in relation to the plans and estimates used to manage our business. We also consider assumptions that we believe market participants would use in pricing the assets and liabilities. It is possible; however, that the plans may change and estimates may prove to be inaccurate. If actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.

        See Note 2 for further discussion of goodwill and impairment.

• Merchandise Advances / Gift Cards

        Merchandise advances represent layaway deposits which are recorded as a liability pending consummation of the sale when we receive the full purchase price from the customer. Gift certificates, gift cards and credits on account are recorded as a liability until redeemed by the customer.

        Our gift card subsidiaries issue gift cards that are sold to customers in our stores and online. Revenue from gift card sales is recognized upon the redemption of the gift card. Our gift cards do not have expiration dates. Based on historical redemption rates, a certain percentage of gift cards will never be redeemed, referred to as "breakage." We record breakage as a reduction of cost of goods sold for the estimated amount of gift cards that are expected to go unused and that are not subject to escheatment. We recognize gift card breakage proportionally over the estimated period of performance by applying our estimated breakage rate to actual gift card redemptions. Our estimated breakage rate is based on customers' historical redemption rates and patterns.

• Self-Insurance Reserves

        We maintain a self-insurance program for workers' compensation of up to $500,000 per claim and medical insurance of up to $350,000 per claim, with excess amounts covered by stop-loss insurance coverage. Estimated costs under these programs, including incurred but not reported claims, are recorded as expenses based upon actuarially determined historical experience and trends of paid and incurred claims.

        As of December 31, 2011, self-insurance reserves for workers' compensation were $4.3 million and for medical insurance was $1.9 million. As of December 31, 2010, self-insurance reserves for workers' compensation were $3.8 million and for medical insurance was $1.6 million. These balances are included in accrued expenses and other current liabilities in the accompanying consolidated balance sheets.

• Revenue Recognition

        We recognize retail sales at the time of sale, net of a provision for estimated returns.

        We recognize online and catalog sales and shipping and handling fees charged to customers when the products are estimated to be received by the customer, net of a provision for estimated returns. Return allowances are estimated using historical experience.

        We recognize band instrument rentals on a straight-line basis over the term of the rental agreement, unless a trial period is offered, in which case we recognize rental income for the trial period over the term of the trial period. The terms of the majority of our rental agreements do not exceed 36 months. Trial periods are usually from one to four months.

• Shipping and Handling Costs

        We define shipping and handling costs as costs incurred for a third-party shipper to transport merchandise from our stores and our direct response fulfillment center to our customers. Shipping and handling costs are included in cost of goods sold, buying and occupancy in the accompanying statements of operations. Shipping and handling fees charged to customers are included in net sales in the accompanying consolidated statements of operations.

• Advertising Costs

        We expense Guitar Center, direct response non-catalog and Music & Arts advertising costs as incurred. Advertising costs for the Guitar Center and Music & Arts segments were $39.5 million in 2011, $38.3 million in 2010 and $41.8 million in 2009. Direct response non-catalog advertising costs were $20.2 million in 2011, $22.0 million in 2010 and $19.9 million in 2009.

        We capitalize mail order catalog costs on a catalog by catalog basis and amortize the amount over the expected period of future benefits, not to exceed five months. Capitalized mail order catalog costs included in prepaid expenses and other current assets was $1.2 million at December 31, 2011 and $1.5 million at December 31, 2010.

        We evaluate the realizability of capitalized mail order catalog costs at each balance sheet date by comparing the carrying amount of those assets on a cost-pool-by-cost-pool basis to the probable remaining future net revenues expected to result directly from that advertising. If the carrying amounts of deferred mail order catalog costs exceed the probable remaining future net revenues, we write down the excess capitalized amount and expense that amount in the current period. We receive cooperative advertising allowances from manufacturers in order to subsidize advertising and promotional expenditures relating to the vendor's products. We recognize these advertising allowances as a reduction to selling, general and administrative expense when the advertising costs are incurred. We recognized cooperative advertising allowances of $8.7 million in 2011, $9.1 million in 2010 and $8.8 million in 2009.

• Rent Expense

        We lease substantially all of our store locations under operating leases that provide for monthly payments that typically increase over the life of the leases. We expense the aggregate of the minimum annual payments on a straight-line basis over the term of the lease. The amount by which straight-line rent expense exceeds actual lease payment requirements in the early years of the leases is accrued as deferred minimum rent and reduced in later years when the actual cash payment requirements exceed the straight-line expense. When a lease includes lease incentives such as a rent holiday or construction costs reimbursement or requires fixed minimum lease payment escalations, we recognize rental expense on a straight-line basis over the initial term of the lease, and we include the difference between the average rental amount charged to expense and amounts payable under the lease in deferred rent and lease incentives in the accompanying consolidated balance sheets.

        Rent expense related to our stores and rent expense related to our retail store distribution centers is included in cost of goods sold, buying and occupancy in the accompanying consolidated statements of operations. Rent expense related to our corporate offices, call centers and data centers and rent expense related to our direct response fulfillment center is included in selling, general and administrative expenses in the accompanying consolidated statements of operations.

• Income Taxes

        We account for income taxes using the asset and liability method. Under this method, we defer tax assets and liabilities until they are able to be recognized pursuant to tax law. Deferred tax assets and liabilities are measured using enacted tax rates for the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

        We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits of the position, that the position will be sustained upon examination. Our policy is to recognize interest and penalties related to uncertain tax positions as a component of income tax expense.

        In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversals of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. We recognize a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion of a deferred tax asset will not be realized.

        Guitar Center is included in Holdings' consolidated federal and state income tax returns. Because Guitar Center does not have a standalone income tax liability, we allocate income tax provisions using the separate return method. Under this method, current and deferred taxes are allocated to each reporting entity as if it were to file a separate tax return. Differences between the consolidated and separate return income tax provisions are eliminated in consolidation. See Note 10 for additional information regarding income taxes.

• Stock-Based Compensation

        Holdings grants stock-based awards to certain Guitar Center employees under its management equity plan. Guitar Center recognizes the related compensation expense in selling, general and administrative expenses and as a capital contribution from Holdings. Guitar Center itself does not grant stock option or other stock-based compensation to its employees or to third parties.

        Stock-based compensation expense is measured based on the fair value of the award on the grant date and recognized on a straight-line basis over the requisite service period for awards expected to vest. Stock-based compensation expense is recorded net of estimated forfeitures. The forfeiture rate assumption used in determining stock-based compensation expense is estimated based on historical data and management's expectations about future forfeiture rates. Assumptions about forfeitures were developed separately for our senior management from the other participants of our stock plans, as senior management's exercise and retention behavior is expected to differ materially from the other participants. The actual forfeiture rate could differ from these estimates.

• Concentration of Credit Risk

        Our cash deposits are with various high quality financial institutions. Customer purchases generally are transacted using cash or credit cards. In limited instances, we grant credit for larger purchases under customary trade terms. Credit losses have historically been within our expectations.

• Fair Value of Financial Instruments

        The principal amount of our long-term debt is stated at par value and its significant terms are described in Note 5.

        Companies may elect to use fair value to measure eligible items at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are not limited to, accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees, issued debt and firm commitments. We did not elect to apply the fair value option for reporting financial assets or liabilities.

        The fair values of our financial assets and liabilities are discussed in Note 11.

• Comprehensive Loss

        Comprehensive income or loss includes charges and credits to stockholders' equity that are not the result of transactions with stockholders. Our total comprehensive loss consists of net loss and unrealized gains and losses on derivative instruments. The gains and losses on derivative instruments, net of income tax, are included in accumulated other comprehensive loss in the accompanying consolidated balance sheets and statements of stockholders' equity (deficit).

• New Accounting Pronouncements

        In December 2010, the FASB issued revised standards related to performing goodwill impairment testing for reporting units with zero or negative carrying amounts. When a goodwill impairment test is performed (either on an annual or interim basis), an entity must assess whether the carrying amount of a reporting unit exceeds its fair value (step 1). If it does, the entity must perform an additional test to determine whether goodwill has been impaired and to calculate the amount of that impairment (step 2). The revised standards require that for reporting units with zero or negative carrying amounts, step 2 of the goodwill impairment test must be performed if it is more likely than not that a goodwill impairment exists, taking qualitative factors into account. The revised standards eliminate an entity's ability to assert that a reporting unit is not required to perform step 2 because the carrying amount of the reporting unit is zero or negative despite the existence of qualitative factors that indicate the goodwill is more likely than not impaired. The revised standards do not modify existing standards on how to determine the carrying amount or measure the fair value of the reporting unit.

        The revised standards are effective for fiscal years beginning after December 15, 2010, with early adoption prohibited. We adopted the revised standards effective January 1, 2011. The change had no effect on our financial statements.

        In September 2011, the FASB issued revised standards related to testing goodwill for impairment. The new standards permit an entity to assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. The revised standard is intended to reduce costs and simplify how entities test goodwill for impairment.

        The revised standard is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We adopted the revised standard for our annual goodwill impairment test performed during the fourth quarter of 2011. The adoption of the revised standard did not affect our financial statements.

        In May 2011, the FASB issued revised standards related to fair value measurements and disclosures. The revised standards clarify existing fair value measurement principles, modify the application of fair value measurement principles in certain circumstances and expand the disclosure requirements related to fair value measurements.

        The revised standards are effective for interim and annual reporting periods beginning after December 15, 2011, with early adoption prohibited. We do not expect the revised standards to have a material effect on our financial statements.

        In June 2011, the FASB issued revised standards related to the presentation of comprehensive income. The revised standards eliminate the option to present components of other comprehensive income as part of the statement of changes in stockholders' equity and require that all non-owner changes in stockholders' equity be presented either in a single continuous statement of income and comprehensive income or in two separate but consecutive statements.

        The revised standard is effective for interim and annual reporting periods beginning after December 15, 2011 and must be applied retrospectively to all periods upon adoption. We plan to adopt the revised standards on January 1, 2012. The adoption of the revised standard will change the presentation of our consolidated financial statements.