Lease Restatements in theRestaurant Industry, 2004â??2005Prior to 1970, most U.S. firms used leasing

Lease Restatements in theRestaurant Industry, 2004–2005Prior to 1970, most U.S. firms used leasing for short-term needs. A small firm mightlease an office, copier, or manufacturing space for one or two years to limit the riskif the business failed. If a larger firm needed expensive equipment or a building, itoften financed the asset by borrowing from a bank, using the asset as collateral. Nolease accounting rules existed and none were necessary. Firms simply recordedlease expense when they made each month’s rent or lease payment.Beginning in about 1970, U.S. firms realized they could structure long-term leaseagreements that were equivalent to buying an asset with debt. A firm might purchasea $50 million building with a $50 million bank loan to be repaid over a 20-year periodat $410,000 per month (an effective annual interest rate of about 8%). Instead, the firmmight ask its bank to structure the transaction as a $410,000 per month 20-year lease,with the additional stipulation that at the end of 20 years the firm must purchase thebuilding for $1. The firm would also maintain and insure the building.Except for the additional $1 after 20 years, the terms are identical, thus the bankshould be indifferent as to whether the transaction is called a loan or a lease. With alease, however, the firm would not record the building as an asset or record the present value of lease payments as debt. Using the example in the previous paragraph,suppose the firm had $150 million of assets, $50 million of debt, and $100 million ofequity prior to the transaction, its debt-to-equity ratio would have been 0.5. With $50million of added assets and debt, the debt-to-equity ratio would increase to 1.0; witha lease, the ratio would remain at 0.5. Firms began to use leasing as one of the firstforms of off-balance sheet financing. Leasing became so common that in November 1976 the newly established Financial Accounting Standards Board (FASB) issuedguidance on how to account for leases (Section 840, previously FAS 13).ACS 840 (FAS 13), Accounting for LeasesThe FASB classified leases into two categories, shorter-term operating leases andlonger-term capital leases. For an operating lease, the lessee records lease expenseeach month when it pays the rent or lease cost. The journal entry is a debit to leaseor rent expense and a credit to cash, although as discussed later in this case, in practice the journal entries are more complex.With a capital lease, the lessee records the lease so it is equivalent to buying an asset with debt. Thereafter, the lessee separates lease payments into an interest component and a partial principal repayment. The lessee also depreciates the leased assetover the lease term, as if it bought the asset with borrowed funds.Capital Lease ExampleExhibit 1 provides a simple example of a two-year capitalized lease. Typically, capitalleases are for much longer periods, but conceptually they are identical to this example. The lessee makes a $10,000 lease payment at the beginning of each month, starting January 1, 2008 (second column). The lessee computes the lease’s present value,which requires a discount rate. FASB’s guidance on accounting for leases requires12SECTION THREEFINANCIAL REPORTING—U.S. GAAPthat the rate be the lessee’s incremental borrowing rate, or the rate the lessee couldhave borrowed the funds it needed to purchase the leased asset.1Exhibit 1 assumes an 8% effective annual borrowing rate, or a .643% monthly rate.2The present value of the 24 $10,000 monthly payments is $223,155.73 (the $10,000initial payment, plus the net present value [NPV] of the remaining 23 payments, discounted at .643% monthly). That amount is recorded as a lease asset and a lease liability at the lease inception. Because the lessee pays $10,000 at the beginning of themonth, the present value of the lease liability immediately declines to $213,115.73.During January, the lessee incurs $1,371.45 of interest expense (.643% monthly interest rate, multiplied by the $213,115.73 lease payable at the beginning of January). Thejournal entries to record those transactions are shown at the lower left of Exhibit 1.The lessee also records straight-line depreciation expense each month over the24-month lease term. The journal entries to record the activity for February are shownin the lower right of Exhibit 1.Each month the $10,000 lease payment is separated into two components: interestexpense and principal repayment (repayment of the lease liability). At the end of thelease, the lease liability declines to zero and accumulated depreciation increases to$223,155.73 (the value of the leased asset at inception). Interest expense plus accumulated depreciation equals the $240,000 of lease payments.Had this been recorded as an operating lease, the lessee would have debited leaseexpense and credited cash for $10,000 each month. Total expenses would still be$240,000, but the lessee would not have recorded a lease asset or a lease liability atlease inception.Test for Operating or Capital LeaseOperating leases are short-term leases with few ownership characteristics. If a realtorleases 750 square feet of office space for a year, with no requirement or incentive torenew the lease, there is no reason to believe the lease is equivalent to buying theoffice space. In contrast, capital leases have substantial ownership characteristics.The guidance on accounting for leases established four tests for a capital lease; if alease passes any of the following four tests (slightly simplified), then it is classified asa capital lease: lease transfers ownership to the lessee at the end of the lease.The lease contains a bargain purchase option.The lease term is equal to 75% or more of the economic life of the leased property.The present value at the lease inception of the minimum lease payments equals90% or more of the fair value of the leased property.3The first two tests are relatively straightforward; the last two are not. If the leaseterm is equal to 75% or more of the economic life of the leased property, then thelease is a capital lease. An asset’s economic life, however, is highly subjective. Insome instances, such as semiconductor production, equipment becomes obsoletein 2 or 3 years; in other instances, equipment may be used for 50 or 75 years. As aresult, firms can often justify an economic life far beyond the lease term and therebycircumvent the third test.1. ACS 840; previously FAS 13, Lease Accounting, Financial Accounting Standards Board, November1976, paragraph 7.2. 1.08 ^ (1/12) – 1 = 0.00643.3. FAS 13, paragraph 5, subparagraph L.CASE 3.2LEASE RESTATEMENTS IN THE RESTAURANT INDUSTRY, 2004–2005The fourth test, although far less subjective than the third, is subject to manipulation. Sometimes a firm’s incremental borrowing rate is readily determined, but oftenit is not. As a result, some firms have assumed unrealistically high borrowing rates tocircumvent the fourth test. There are also many subtleties that the last test does notaddress. For example, suppose the lease term for a building is 10 years and the present value of the lease payments is only 60% of the building’s fair value. That clearlydoes not equal or exceed the 75% requirement of the fourth test, so the transactionseems to qualify as an operating lease.However, suppose that if the lessee fails to renew the lease for a second 10-year period, the lessee must pay a $15 million penalty. As another alternative, suppose thereis no failure-to-renew penalty, but that the lessee guarantees the building will have afair value of at least $30 million at the end of the 10-year lease. Over the years, a largenumber of issues arose that were not fully addressed by the guidance on accountingfor leases. As a result, the FASB, Securities and Exchange Commission (SEC), andAmerican Institute of Certified Public Accountants (AICPA) issued about 100 additional leasing guidelines, clarifications, and rules.As the rules for leases and other accounting issues became more complex, largeCPA firms established technical groups to provide guidance to engagement partners(partners responsible for conducting an audit). Technical groups include senior partners and managers who are experts in fields such as revenue recognition, leasing,derivatives, hedging, employee compensation, taxes, and international operations.In these areas, accounting rules are detailed, complex, and unsettled.Each of the four large accounting firms (Deloitte & Touche, Ernst & Young, KMPG,and PwC) has a technical group of at least 100 partners and managers. The groupsreceive several thousand relatively formal inquiries each month from engagementpartners and managers, although many partners call their technical groups almostdaily with less formal questions. Technical groups can sometimes answer a questionwith little or no research but usually research a topic and then provide an answer. Inmany instances they must contact technical groups of the other big four firms or, ifnecessary, the FASB and SEC.In contrast, the International Financial Reporting Standards (IFRS) has only one leasing standard, International Accounting Standard (IAS) 17, Leases. The IFRS standardhas five tests for whether a lease is a finance (the IFRS term for capital lease) or operating lease. The first two are very similar to those under U.S. GAAP. IFRS takes a moregeneral view on the next two. Instead of a lease term that is 75% or more of the asset’slife, IAS 17 requires that “the lease term is for the major part of the economic life ofthe asset even if title is not transferred.†Instead of 90% or more of the asset’s presentvalue, IAS 17 requires that “at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leasedasset.†In practice, at least some of the large accounting firms simply use the 75% and90% bright-line tests from the lease accounting guidance under U.S. GAAP when applying lease accounting to firms that report under IFRS. The IFRS also requires that a leasebe capitalized (reported as a finance lease) if “the leased assets are of such a specialized nature that only the lessee can use them without major modification.â€Leasing Problems in the Restaurant IndustryPrior to 2002, the AICPA administered peer reviews in which CPA firms reviewed thework of similar-size firms. In response to perceived widespread financial manipulation, in 2002 the U.S. Congress passed the Sarbanes-Oxley Act. Part of that actestablished the Public Company Accounting Oversight Board (PCAOB), which replaced peer reviews with a far more rigorous PCAOB inspection process. In 2003, the34SECTION THREEFINANCIAL REPORTING—U.S. GAAPPCAOB conducted limited inspections of the four remaining large CPA firms. In 2004,the PCAOB began conducting complete inspections annually for all CPA firms with100 or more publicly traded clients and every three years for those with at least 1, butfewer than 100, publicly traded clients.During the initial PCAOB inspections of the accounting firm audits, PCAOB accountants identified numerous problems with how publicly traded companies accountedfor operating leases. The PCAOB discovered four main issues (all now covered byACS 840-20 [Operating Leases]):1. FASB Technical Bulletin 85-3 requires that payments under operating leases withscheduled rent increases must be expensed on a straight-line basis over the leaseterm. Suppose a three-year operating lease requires monthly lease payments of$10,000 in 2008 and, to cover anticipated inflation, payments of $10,400 in 2009 and$10,800 in 2010. Under this rule, the firm records monthly lease expense of $10,400 foreach of the 36 months. During the first year, the firm debits rent expense for $10,400,credits cash for $10,000, and credits lease liability for $400. During the last year, thefirm debits rent expense for $10,400 and lease liability for $400 and credits cash for$10,800. Many firms simply recorded their monthly cash payment as lease expense.2. Tenants often modify leased space before moving into the property. These leaseholdimprovements are usually capitalized and then amortized over the shorter of the assetlife or the lease term. Landlords often provide tenants with cash incentives to offset thecost of modifying rental space. A retail clothing store may wish to construct changingrooms, a fitting room, check-out counters, and display areas using a corporate-widedesign theme. Suppose the construction cost and cash incentive are each $300,000and the lease term is 60 months. FASB Technical Bulletin 88-1 (and other rules)requires that firms record the $300,000 cash received as a liability and the $300,000paid as an asset. Thereafter, each month the tenant debits the liability for $5,000and credits rent expense for $5,000. Assuming the improvements have a 60-monthlife, the tenant also debits depreciation expense for $5,000 and credits accumulateddepreciation for $5,000. Many firms simply offset the cash incentive against the costof leasehold improvements at the lease inception, so no additional accounting wasneeded other than to debit lease expense and credit cash each month.3. FAS 98, Accounting for Leases, requires that leasehold improvements be amortizedon a straight-line basis over the shorter of either the lease term or the estimateduseful life of the leasehold improvement. If a lease contains a renewal option, thelease term should include both the initial lease term, plus the renewal period,only if the renewal is reasonably assured. For example, if the lessee must paya substantial penalty for failing to renew, then the renewal may be reasonablyassured. Many firms included the renewal period as part of the period overwhich leasehold improvements were amortized, even though renewal wasnot reasonably assured under the FASB definition. In other instances, lesseesamortized leasehold improvements only over the initial lease period even though,under FASB rules, renewal seemed to be reasonably assured.4. Landlords often provide tenants with a rent holiday; for example, no rent duewhile the space is being modified. Suppose a tenant signs a 60-month leaseat $10,000 per month, but the landlord waives rent for the first 2 months whilethe tenant constructs leasehold improvements. Under ACS 840-20 (previouslyTechnical Bulletin 85-3), the lessee must spread the $580,000 of lease expenseover the entire 60-month period on a straight-line basis ($9,666.67 per month).Many firms recorded no lease accounting entries during the first 2 months andthen recorded $10,000 of rent expense for each of the remaining 58 months.CASE 3.2LEASE RESTATEMENTS IN THE RESTAURANT INDUSTRY, 2004–2005Partially in response to the PCAOB inspection findings, numerous companiesfiled restated financial statements with the SEC to correct some or all of the aboveerrors. Because lease accounting errors were so widespread, the AICPA asked theSEC whether it was necessary for firms to restate their previously issued financialstatements to correct their lease accounting. In response, the SEC sent the AICPA theletter in Exhibit 2.Although the above problems were not restricted to restaurant and retail chains,the larger chains have hundreds of or thousands of leases, so their problems wereoften significant. The following is a partial list of restaurants and other retailers withlease accounting issues for 2004 or 2005:Abercrombie & FitchApplebee’sBenihanaBig LotsBorders GroupBrinker InternationalBuca di BepposCKE RestaurantsCracker BarrelDarden RestaurantsDollar GeneralJack in the BoxKohl’sKrispy Kreme DoughnutsLone Star SteakhouseLowe’sMcDonald’sPep BoysRubios RestaurantsRuby TuesdaySearsStarbucksTargetTotal EntertainmentRestaurantToys ‘R UsTully’s CoffeeBrinker InternationalBrinker International owns Chili’s, On the Border, Maggiano’s Little Italy, andRomano’s Macaroni Grill. On December 22, 2004, Brinker filed a Form 8-K with theSEC detailing the following problems with its lease accounting:Following a review of its accounting policy and in consultation with its independent registered public accounting firm, KPMG LLP, the company has corrected itscomputation of straight-line rent expense and the related deferred rent liability. Thismove is similar to recent restatements announced by other KPMG client restaurantcompanies.Historically, when accounting for leases with renewal options, rent expense has beenrecorded on a straight-line basis over the initial non-cancelable lease term. Buildings and leasehold improvements on those properties are depreciated over a periodequal to the shorter of the term of the lease—including option periods provided forin the lease—or the useful life of the assets. Brinker will recognize rent expense ona straight-line basis over sufficient renewal periods to equal the depreciable life of20 years, including cancelable option periods where failure to exercise such optionswould result in an economic penalty.For the year ended June 30, 2004, correcting the errors in lease accounting, and anotherminor item, reduced after-tax net income from $153.961 million to $150.918 million.Starbucks CorporationStarbucks determined in 2005 that its then-current method of accounting for leasehold improvements under operating leases (tenant improvement allowances) and itsthen-current method of accounting for rent holidays were not compliant with GAAP.The company restated its financial statements for fiscal years 2004, 2003, and 2002.56SECTION THREEFINANCIAL REPORTING—U.S. GAAPStarbucks included the following in Item 6. Selected Financial Data, in the Management Discussion and Analysis section of its 2004 10-Q:The Company had historically accounted for tenant improvement allowances asreductions to the related leasehold improvement asset on the consolidated balancesheets and capital expenditures in investing activities on the consolidated statementsof cash flows. Management determined that Financial Accounting Standards Board(“FASBâ€) Technical Bulletin No. 88-1, Issues Relating to Accounting for Leases,requires these allowances to be recorded as deferred rent liabilities on the consolidatedbalance sheets and as a component of operating activities on the consolidatedstatements of cash flows. Additionally, this adjustment results in a reclassification ofthe deferred rent amortization from “Depreciation and amortization expenses†to “Costof sales including occupancy costs†on the consolidated statements of earnings.The Company had historically recognized rent holiday periods on a straight-linebasis over the lease term commencing with the initial occupancy date, or the opening date for Company-operated retail stores. The store opening date coincided withthe commencement of business operations, which corresponds to the intendeduse of the property. Management reevaluated FASB Technical Bulletin No. 85-3,Accounting for Operating Leases with Scheduled Rent Increases, and determinedthat the lease term should commence on the date the Company takes possessionof the leased space for construction purposes, which is generally two months priorto a store opening date. Excluding tax impacts, the correction of this accounting requires the Company to record additional deferred rent in “Accrued occupancy costsâ€and “Other long-term liabilities†and to adjust “Retained earnings†on the consolidated balance sheets as well as to correct amortization in “Costs of sales includingoccupancy costs†on the consolidated statements of earnings for each of the threeyears in the period ended October 3, 2004. The cumulative effect of these accounting changes is a reduction to retained earnings of $8.6 million as of the beginningof fiscal 2002 and decreases to retained earnings of $1.3 million, $1.5 million and$1.2 million for the fi scal years ended 2002, 2003 and 2004, respectively (Note:Starbuck’s retained earnings were restated downward from $2.487 billion to $2.474billion at the end of fiscal 2004.)Required1. Suppose you were advising the CEO and CFO of Brinker International orStarbucks Corporation about whether to restate financial statements for theerrors discussed in this case. After reading SEC Chief Accountant Donald T.Nicolaisen’s letter to the AICPA, what would you recommend?2. Evaluate the four operating lease rules discussed in this case. Are the rulesneeded? How difficult are the lease rules to implement in a large restaurantchain or retail chain, with hundreds or thousands of leases? As part of youranswer, would it be reasonable for these chains to force landlords to enter intoleases with standard terms that would simplify their lease accounting?3. U.S. firms may soon shift to International Financial Reporting Standards (IFRS),where accounting standards are based far more on general principles thanon highly detailed rules. For example, the International Accounting StandardsBoard has one standard on leases (IAS 17, Leases), and two lease interpretations(IFRIC 4, Determining Whether an Arrangement Contains a Lease, and SIC-15,Operating Leases—Incentives). Discuss the advantages and disadvantages of farless detailed rules.4. The IASB is considering a highly simplified lease accounting rule that wouldrequire firms to capitalize all leases with a term of more than two or three years.Discuss the advantages and disadvantages of such a simple rule.CASE 3.27LEASE RESTATEMENTS IN THE RESTAURANT INDUSTRY, 2004–2005EXHIBIT 1CAPITAL LEASE E XAMPLE: LESSEEAnnualized interest rateMonthly interest ratePresent value of lease paymentsJanuary-08February-08March-08April-08May-08June-08July-08August-08September-08October-08November-08December-08January-09February-09March-09April-09May-09June-09July-09August-09September-09October-09November-09December-09Depreciation expenseInterest expenseTotal expenseReduction to lease payableTotal lease payments8.000%0.643%$223,155.73Lease payment, Lease payable,beginningbeginningof monthof month$10,000$213,155.73$10,000$204,527.18$10,000$195,843.11$10,000$187,103.17$10,000$178,307.00$10,000$169,454.23$10,000$160,544.50$10,000$151,577.45$10,000$142,552.71$10,000$133,469.89$10,000$124,328.64$10,000$115,128.58$10,000$105,869.32$10,000$96,550.49$10,000$87,171.69$10,000$77,732.56$10,000$68,232.69$10,000$58,671.70$10,000$49,049.20$10,000$39,364.78$10,000$29,618.06$10,000$19,808.62$10,000$9,936.07$10,000$0.00Lessee Journal EntriesJanuary 1, 2008Lease assetLease liabilityLease asset and liability at inceptionLease liabilityCashFirst lease paymentJanuary 31, 2008Interest expenseAccrued interest (liability)Interest expense, JanuaryDepreciation expenseAccumulated dep, leased assetDepreciation expense, JanuaryInterestexpensefor month$1,371.45$1,315.93$1,260.06$1,203.83$1,147.23$1,090.27$1,032.95$975.25$917.19$858.75$799.93$740.74$681.17$621.21$560.87$500.13$439.01$377.50$315.58$253.27$190.56$127.45$63.93$0.00Reductionto leasepayable$8,628.55$8,684.07$8,739.94$8,796.17$8,852.77$8,909.73$8,967.05$9,024.75$9,082.81$9,141.25$9,200.07$9,259.26$9,318.83$9,378.79$9,439.13$9,499.87$9,560.99$9,622.50$9,684.42$9,746.73$9,809.44$9,872.55$9,936.07$16,844.27Depreciationexpense$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$9,298.16$223,155.73 $223,155.73$16,844.27$240,000.00$213,155.73$240,000$223,156$223,156February 1, 2008Accrued interest (liability)Lease liabilityCashSecond lease payment$1,371.45$8,628.55$10,000.00$10,000$10,000February 28, 2008Interest expenseAccrued interest (liability)Interest expense, February$1,315.93$1,315.93$1,371.45$1,371.45$9,298.16$9,298.16Depreciation expenseAccumulated dep, leased assetDepreciation expense, February$9,298.16$9,298.168SECTION THREEFINANCIAL REPORTING—U.S. GAAPEXHIBIT 2SEC STAFF LETTERTO THE AICPA:LEASESRobert J. KueppersChairmanCenter for Public Company Audit FirmsAmerican Institute of Certified Public AccountantsHarborside Financial Center201 Plaza ThreeJersey City, NJ 07311-3881February 7, 2005Dear Mr. Kueppers:In recent weeks, a number of public companies have issued press releases announcingrestatements of their financial statements relating to lease accounting. You requested thatthe Office of the Chief Accountant clarify the staff’s interpretation of certain accountingissues and their appli…

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