Dozens of companies have had to restate, adjust or delay earnings reports in recent months because of problems they've had in accounting for leases. Now some experts are warning that the restatements could be a sign of deeper problems.
The issue has come to light as scrutiny has intensified on public companies' accounting methods. The Sarbanes-Oxley Act -- Congress' response to the accounting scandals earlier in the decade -- has forced companies and their auditors to examine accounting procedures and controls, as well as require corporate executives to verify the accuracy of their companies' financial reports.
As part of this, auditors and companies started to raise questions about properly accounting for leases. In a letter sent in February to the chairman of the American Institute of Certified Public Accountants, Donald Nicolaisen, the
Securities and Exchange Commission's
chief accountant, addressed the issues involved:
Under GAAP, the period over which companies depreciate improvements to a property, and the term of the lease, should be the same, according to Nicolaisen. In contrast, many companies had chosen to use a longer term to depreciate the improvements, arguing that leases can often end long before the expected life of buildings, carpeting or other improvements.
Many landlords give companies a "rent holiday" before they have to begin paying rent. Under accounting rules, companies are required to show lease expenses even during that rent-free period, essentially using an average payment of the duration of the lease, according to Nicolaisen. But many companies typically recorded rent expenses only after their actual lease started -- or after they started paying rent.
If landlords pay for improvements or give companies money to do so, accounting rules require companies to detail those incentives, according to Nicolaisen. Instead, some companies recorded only their net improvement costs, which excluded those payments or the value of those services.
"To the extent that
public companies have deviated from the lease accounting standards and related interpretations ... those
companies ... should assess the impact of the resulting errors on their financial statements to determine whether restatement is required," Nicolaisen wrote.
Many have done just that. Through April 1, 221 companies have either restated their past financial reports, adjusted their accounting or warned that they are assessing their accounting, all because of the lease issue, according to Jack Ciesielski, publisher of the
Analyst's Accounting Observer
newsletter. Of those, 27 companies have reported a "material weakness" in their internal controls related to the lease accounting issue, according to data compiled by the Corporate Executive Board.
Among the companies affected are
, which last month
delayed its fourth-quarter report to assess its lease accounting, and
, which reported that while
it had not been accounting for leases correctly, the change would have no effect on its financial statements from 2004 or the first quarter of 2005.
In explaining how they got the accounting wrong, companies and industry representatives have said they were generally following a long-standing industry practice, and noted that the Big Four accounting firms generally signed off on their reports. Regardless of the SEC's position on the matter, Nicolaisen's statement amounted to a change in interpretation of the underlying accounting standards, said David Hirschmann, a senior vice president at the U.S. Chamber of Commerce.
"If it's the wrong answer, everybody was using the wrong answer," said Hirschmann. "The reality is that virtually every company was accounting for leases in the same way."
spokesman Tom Fitzgerald declined to comment on the lease accounting issue. Representatives of the other Big Four accounting firms did not return calls seeking comment.
But accounting experts argue that it's a poor excuse for bad accounting.
"If 1,000 people do a foolish thing, it's still a foolish thing, regardless of whether everyone is doing it or not," said Ciesielski.
As was the case with Starbucks, many of the lease accounting changes have had a minimal impact on companies' reported results, accounting experts say. But that doesn't mean that the issue is necessarily a small one, they argue.
While the lease restatement may represent just a couple of pennies of earnings per year, those pennies add up, said Ciesielski. Though the question of how long companies have been misreporting their lease expenses is as yet unclear, it indicates that the misreporting could date back to the 1980s, he said. If so, that could have big implications for reported earnings -- and stock market prices, he said.
"There may be some big stock market value accumulated over years that maybe shouldn't be there," Ciesielski said.
More troublesome, perhaps, is the notion that problems with lease accounting may indicate bigger problems within companies' financial reports. The accounting troubles and governance issues at
( FNM) and
, for instance, started with just one or two issues but later mushroomed, noted Lynn Turner, the former chief accountant of the SEC and currently the managing director of research at proxy adviser Glass Lewis.
That's not to say that just because a company misreported its lease accounting it necessarily has other accounting issues. But the reports do deserve further scrutiny, said Turner.
"If, on this one, the auditors turned a blind eye, and companies got it wrong -- since this is black and white -- isn't it logical for an investor to ask, 'What else?' That's not a dumb question for an investor to ask, in light of all the restatements in the past several years," said Turner.
The lease expense problems represent "sloppy accounting," said Charles Mulford, professor of accounting at Georgia Tech's college of management. The rash of restatements likely will end the lease accounting issue, but it raises the question of whether companies were similarly lax in other areas of their reports, he said.
"They showed us that they had an accounting system in place that allowed a lot of sloppiness to go on. Where else might it lie," he said.
But others are less worried about the issue. The accounting departments at many companies have been underfinanced for years, noted Ciesielski. As a result, those companies likely had to pick and choose which accounting areas to focus on, he said.
"If they were going to screw something up, if they were going to relax on vigilance, I'm glad they were doing it here," he said. "It doesn't make me sleep better at night. I'm just grateful that this is as bad as it could be."
Still, some accounting experts and some in the industry worry that the focus on lease accounting may be misplaced, particularly if it forces companies to have to report material weaknesses in their financial reports.
"I'm not defending or excusing not doing it right," said Jeff Brotman, a professor of accounting at the University of Pennsylvania's law school and the managing partner of Philadelphia-based Ledgewood Law Firm. But he says, "you ask yourself, just how significant is this really?"
And Hirschmann goes further. Forcing companies to report that they have a "material weakness" in their accounting because of the lease expense issue could confuse the market, drawing attention away from companies that have much more significant accounting issues.
"When an entire industry is reporting a material weakness because of an accounting rule change at the eleventh hour, it doesn't provide shareholders of those companies valuable information," he said.