Lease Restatements: They’re Not Just For Restaurants Anymore

The restaurant sector has been going through mini-seizures in the past couple of months over the restatement of previously issued financial statements. The reason for the restatements: incorrect accounting for leases. A number of restaurant firms have already announced restatements and their effects – crypto Custodian, Jack In The Box, Brinker International, Darden Restaurants, and Ruby Tuesday – according the Wall Street Journal. Others in the same industry are still pondering their lease accounting. A good discussion is in the CKE Restaurants 8-K of November 23, 2004.

The problem generally revolves around a mismatch: a company may lease property, account for it as an operating lease over the initial term and recognize rental expense over that same period. (No asset, no debt, just rental expense.) The rub comes in when the firm capitalizes improvements it places on the rented property and depreciates them over a longer term – say, the initial rental period, plus periods covered by expected renewals. If you don’t have the right to use the property that the improvements sit upon after a certain number of years, does it really make sense to depreciate it over a longer period than that? It’s like depreciating a building with an expected economic life of 40 years, putting a new roof on it in the 30th year. Maybe the roof will last 25 years, but does it makes sense to do that if the rest of the building is expected to be worthless in 10 more years?

(Time for a disclosure: KPMG is a subscriber to The Analyst’s Accounting Observer. It makes no difference to me, but some people breathe heavily about these things.)

So far, there have been two constants in these lease-driven restatements: they’ve been in the restaurant business, and the auditor has been KPMG. That leads some observers to conclude that perhaps KPMG has had a faulty firm policy for lease accounting that they pushed onto their restaurant clients. Maybe, maybe not; the circumstances are pretty damning, but nobody can say for certain.

Lately, there have been a couple of new entrants to the lease-restatement game, and in other industries: yesterday, Pep Boys filed an 8-K detailing their restatement, and last Thursday, Siebel Systems mentioned a similar problem. Pep Boys’ auditor is Deloitte & Touche; Siebel Systems’ is KPMG.

No matter who the auditor is, or what industry, seeing restatements is not coming as a surprise as firms grind through their internal contol reviews in preparation for their initial reports thereon. Best guess: now that it’s known that there’s been low-grade accounting for leases making some headlines, firms and their auditors will check to see if their own policies make sense. Rational behavior, I’d say; don’t ignore the obvious. Expect more lease-driven restatements, and not just in one industry or in clients of one audit firm.