Case Study: “Leasing Restatements in the Restaurant Industry” 

Case Study: “Leasing Restatements in the Restaurant Industry” 

• From the case study, create an argument for the use of principles-based accounting for leases over rules-based accounting under GAAP, based on the financial statement restatements in the restaurant industry. Provide support for your argument.

Unethical accounting practices enabled companies like Enron and WorldCom to bilk investors out of huge sums of money. In response, Congress passed the Sarbanes-Oxley Act of 2002 to authorize the Securities and Exchange Commission to explore reforms to rules-based accounting systems. I prefer principle based accounting over One argument in support of principles-based standards is that in theory they force financial statement preparers (and auditors) to consider how possible accounting alternatives reflect economic substance and to judge the most suitable accounting treatment. Advantages include clarity in application, reduction of risk , and comparability for companies in the same industry for the same rule.

• Assess the materiality of the errors, direction provided by the Securities and Exchange Commission (SEC), and the Sarbanes-Oxley Act (SOX) on the decision by management to restate the financial statements. Indicate the likely impact to stakeholders when financial statements are restated.

Sarbanes-Oxley Act was passed by Congress for the reason of transparency in reporting. In my opinion, the principle-based accounting for leases allows more transparency as compared to the rules-based accounting. Principles based accounting just shows way as a guide instead of firm rules, whereas rules-based is strict and firm to follow the rules. Most of the times, lease is not firm, and so rules based accounting does not work for those, on the other hand principle-based accounting covers very broad and practical approach for many situations.  Sometimes Manager needs flexibility to fit in their business situations, so rule-based straightness does not work for them, whereas principle-based takes into consideration that there every situation could not be the same.  For example, the Public Company Accounting Oversight Board sited one of the issues that was scheduled rent increases.  For example, a company rents out a space and tenant is required to pay $500 a month for the first year and second year increase $50 to make it $550 a month, and third year tenant pay $600, so the rental expense is consistent over the life of the lease.  So under rule based accounting, tenants would record their monthly rent payment as lease expense. But under the principles based accounting, the lease must be expensed on the straight-line basis. This issues is now addressed by ACS 840-20 (Operating Leases). It assesses the materiality of the errors, direction provided by the Securities and Exchange Commission (SEC), and the Sarbanes-Oxley Act (SOX) on the decision by management to restate the financial statements. It also provides information to stakeholders when financial statements are restated. It has happened in the past that many companies’ net income gets decreased by millions of dollars, which makes stakeholders began to worry and wonder what went wrong to the company to bring such a restatement.  And the reason is many corruption scandals and many other quickly bailed out before it is too late.

• From the case study, create an argument for the use of principles-based accounting for leases over rules-based accounting under GAAP, based on the financial statement restatements in the restaurant industry. Provide support for your argument.

The financial statement restatements in the restaurant industry were necessary because many of the companies failed to follow the rules for operating leases under GAAP – such as spreading the costs for leases with scheduled rent increases equally over the term on the lease, or correctly recognizing rent holiday periods .  If these companies were reporting under the more transparent principles based IFRS instead of the strict rules based U.S. GAAP, then the statements would be far simpler, and less expensive to prepare as none of the four rules would have to be followed by the restaurants who, for McDonalds and Starbucks, could have thousands of leases in the U.S. IFRS allows increased flexibility in reporting, and in the case of Starbucks, they could have simply expensed the lease payment for the 2 month rent holiday periods rather than create accruals and make additional Journal entries.

• Assess the materiality of the errors, direction provided by the Securities and Exchange Commission (SEC), and the Sarbanes-Oxley Act (SOX) on the decision by management to restate the financial statements. Indicate the likely impact to stakeholders when financial statements are restated.

Brinkers International restatement was altered by millions, and I think that in the wake of Enron and the introduction of the Sarbanes-Oxley Act, management were fearful of high penalties and were more willing to reissue their statements if errors were found for fear of prosecution by the SEC.  I think that the letter from the SEC gave no direction as to how the companies should proceed as it simply reiterated the technical bulletins.  I think that anytime when a company chooses to restates it’s financial statements, it is a major concern for investors and stakeholders.  However, I think that investors would be most concerned when the restatement has a dramatic effect on income,  liquidity and the company’s financial position and not all of these restaurant restatements did that – most were understating rental expenses and incorrectly reporting lease obligations and if investors looked into the notes, they would see that the companies were trying to rectify errors that were not intentional. However, I think that any restatement reflects poorly on the company and may reduce investors confidence in that company’s internal controls and financial reporting ability.