This case discusses four detailed operating lease rules that many restaurant chains failed to follow. After the PCAOB released its first inspection reports in mid-2005, about 35 restaurant chains restated their financial statements for minor amounts because of detailed lease rules that had little effect on their income statements or balance sheets. One rule requires that lease costs for leases with escalation clauses must be spread equally over the lease term, even if the escalation only covers inflation. Another requires that the benefit from lease or rent “holidays” must be spread over the entire lease term, including the month of the lease holiday. A third rule requires that build-out allowances must be capitalized, which has virtually no effect on net income, but does add an amount to both assets and liabilities. A fourth rule requires that tenants spread the cost of leasehold improvements over the lease term or the life of the improvement. Some firms recorded costs too quickly because they failed to include a probable lease renewal period; other firms recorded costs too slowly because they included a lease renewal period that was not probable.
This case is excellent for considering the difference between rules based U.S. GAAP and principles based IFRS, which includes none of these four rules. I use the case to consider how difficult it would be to implement these four rules. If a company has one or two high-value leases, it is trivial to implement the rules. However, consider a firm with several thousand low-value leases. Although a firm may prefer a standard lease, if a property owner has a desirable location, that property owner may demand a non-standard lease. As a result, it could be highly cost ineffective to implement these four accounting rules; someone may need to re-evaluate each lease annually.
The case includes a letter from the SEC’s Chief Accountant to the AICPA in response to an AICPA letter asking if it was necessary for firms to restate their financial statements. The letter says absolutely nothing. Because of the potential criminal liability under Sarbanes-Oxley, most firms that had not complied with the lease rules restated their financial statements, even when the differences were immaterial.