Almost overnight, lease accounting has morphed into one of the profession's biggest headaches, as more than 300 companies have had to restate their financials, citing, among other issues, corrections to lease accounting errors.

In April, 58 companies, primarily in the retail and restaurant sectors, revealed material weaknesses in lease accounting, while these errors - an issue bought to the forefront recently by the Securities and Exchange Commission - comprised 22.5 percent of internal control weaknesses reported in April, up from less than 10 percent of weakness disclosures in March.

In February, Donald T. Nicolaisen, the SEC's chief accountant, wrote to Robert J. Kueppers, chairman of the American Institute of CPAs' Center for Public Company Audit Firms, setting out the rules for accounting and disclosure of lease expenses and leasehold improvements.

While the SEC contends that the accounting rules for leases aren't new, nor are the interpretations set out in the letter to the AICPA, there appears to be a direct connection between the SEC's letter and the restatement rampage.

According to Lillian Ceynowa, director of the Center for Public Company Audit Firms, there were some restatements prior to the SEC's letter. "As a result of those restatements, a lot of members' clients were asking questions because they were in the same industry - initially in the retail industry - and a lot of questions were going to the auditors. A lot of companies were actually calling the SEC and asking questions," said Ceynowa.

In light of the fact that the Sarbanes-Oxley Act was being enacted for the first time, and in particular Section 404 - which requires management responsibility for establishing and maintaining adequate internal control over financial reporting - combined with the apparent confusion over the lease rules, the SEC felt that it was important to get information about the lease rules out quickly.

The decision was made to draft the Kueppers letter describing what the SEC had been seeing on financial statements and explaining what the correct accounting should be. The letter provided "a reiteration of existing standards that should be followed," Ceynowa said.

The SEC's letter focuses on three areas of lease accounting:

* Amortization of leasehold improvements. Typically, LHI in an operating lease should be amortized over the shorter of their economic lives or the term of the lease.

* Rent holiday. Rent-free or reduced rent periods as part of an operating lease typically should be expensed on a straight-line basis over the lease term, including the rent holiday period.

* Landlord/tenant incentives. LHIs made by the tenant but funded by the landlord under an operating lease should be recorded as assets and amortized in the same way as tenant-funded LHIs.

Such incentives provided by the landlord should be recorded as deferred rent and amortized as reductions to lease expense over the lease term, and not netted against leasehold improvements, and the tenant's statement of cash flows should reflect cash incentives received from the lessor as operating activities and the cash cost for LHI as investing activities.

The letter seemed to set off a chain reaction of restatements, particularly in the retail industry, where often companies have many active rentals.

New Jersey-based arts and crafts retailer A.C. Moore, operator of nearly 100 stores in the eastern United States, is one of the retail companies that indicated plans to make a change in its accounting as a direct result of the SEC letter.

Les Gordon, A.C. Moore's chief financial officer, explained the logic behind the company's reassessment of its accounting procedures: "The reason is that, historically, landlords have granted us access to the property free of charge in order to build out or fixture the store and stock it with merchandise prior to opening our doors for business. ... The views expressed by the SEC were in disagreement with longstanding accounting practices that have been used by A.C. Moore and pervasively in the retail industry," he said.

At the very least, many companies delayed presentation of financial statements this spring as a result of the need to reassess their accounting after the publication of the letter.

The press releases from affected companies recite the same chorus, over and over again: "In light of [the SEC's] letter, management initiated a review of its lease-related accounting methods... The company determined that its methods of accounting for leases ... while in line with common industry practices, were not in conformity with GAAP."

Brad Saltz, who specializes in restaurant services as a director at Ohio-based SS&G Financial Services, claims that there are two reasons for the restatements. "One, many companies have quite frankly been doing things incorrectly," he said. "It centers around the use of renewal periods in leases. Companies were including renewal periods when calculating depreciation to get a longer life, but when calculating straight-line rent, they were not including them because it leads to lower rent. It gives them the best of all worlds, and accountants were looking the other way."

The second reason for restatements centers on the interpretation of the rent holiday, according to Saltz. "What happens is accountants have known all along that once your lease starts and you have a free rent period, that you have to allocate part of the rent from the rest of the lease back to the free period," he explained. "It's pretty typical that during a construction period you aren't paying any rent."

"The fact is that the SEC came out and took a new interpretation of how they define the rent holiday period to now include the construction period. That's what came out of the blue," Saltz continued. "Companies have been doing it incorrectly for years."

In point of fact, FASB Technical Bulletin 85-3, "Accounting for Operating Leases with Scheduled Rent Increases," addresses the issue of rent holidays and how such rent inducements should be treated: "The effects of those scheduled rent increases, which are included in minimum lease payments under [FASB] Statement 13, should be recognized by lessors and lessees on a straight-line basis over the lease term. ..."

"Most leases have built-in escalations over the term of the lease," explained Fred Gold, a partner in super-regional firm J.H. Cohn, LLP. "Many times a landlord will give a tenant a rent holiday for six months or a year and then make it all up over the remaining term of the lease. What the accounting requires is that you don't recognize rent expense based on your cash payments, but rather taking the total rent that will be paid over the entire term of the lease and divide by the number of years, so you get an equal charge each year."

"It's a way to take the total economics of the lease, the good and the bad, and spread it equally over the term of the lease," said Gold. "I think this is the correct way to do it."

Gary Levy, partner-in-charge of the hospitality services group at J.H. Cohn, noted that the business community is upset with the emphasis on required restatements as a result of lease accounting.

"With all the compliance issues with Sarbanes-Oxley, now they have to restate financials, it's not allowing them to focus on running a business," he said.

Perhaps the most conspicuous response to the lease issue was uttered by Bob Merritt, chief financial officer of the Outback Steakhouse chain, who announced his resignation in conjunction with the company's first quarter 2005 earnings conference call with restaurant industry analysts.

In an emotional speech, he said, "For some time I've been struggling with the increasingly negative regulatory environment in which we now operate. The recent lunacy over lease accounting, as an example, took me past the breaking point."

He seemed particularly troubled by what he called "the reaction of regulators and media, that all of these companies were run by crooks who were cooking the books."

"It is a strong reflection of the growing presumption that all business people are dishonest," Merritt continued.

In its letter, the SEC did not indicate that any of the issues could be characterized as new interpretations of the lease accounting rules. Instead, it appears that, over time, the rules have worked to the benefit of either the companies that participate in a lot of leases or the accountants who would have to calculate the adjustments to rent and amortization expense.

For whatever reason, in many cases, the lease accounting and disclosure rules have not been applied according to the interpretation presented by the SEC this spring.

Apparently, that's all going to change.

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