Academic journal article Academy of Accounting and Financial Studies Journal

An Examination of the Recently Restated Financial Statements Due to Inappropriate Lease Accounting

Academic journal article Academy of Accounting and Financial Studies Journal

An Examination of the Recently Restated Financial Statements Due to Inappropriate Lease Accounting

Article excerpt

ABSTRACT

The purpose of this paper is to describe the history surrounding the recent spike in financial statement restatements related to firms' accounting for leases. The restatements were largely caused by a letter from the SEC emphasizing the rules regarding appropriate accounting for leases. This paper explains why the large number of restatements caused by the SEC letter was such a surprise and discusses the accounting issues raised by the SEC letter. Prior research has found that restatements are more likely in areas where GAAP is contradictory or unclear. GAAP for leases is well established and fairly clear. Also, prior research has found that restatements are more likely due to inappropriate accounting for items that are not part of a company's core earnings. However, in this case the lease accounting that led to the restatements was part of the companies' core earnings. Finally, the paper provides some analysis regarding the commitment to quality financial reporting practices by the companies that restated their financial statements due to inappropriate lease accounting. This analysis indicates that companies that restated did not show lower levels of commitment to quality financial reporting than did firms that did not restate. This evidence is consistent with the conjecture made by many of the companies that restated that they thought their method of accounting for leases was acceptable.

INTRODUCTION

The Sarbanes-Oxley Act of 2002, which came about largely due to the financial scandals at Enron and WorldCom, requires (among other things) that publicly-traded companies review and document their internal controls over financial reporting (Ge and McVay, 2005). While conducting its internal control review in 2004, CKE Restaurants, Inc., owner of Hardee's and Carl's Jr., discovered that it had several errors in its previously issued financial statements that required the statements to be restated. In November 2004, CKE filed a Form 8-K with the SEC and issued a press release explaining the reasons for the restatement, which included problems with how CKE had been accounting for its operating leases.

Shortly after CKE's announcement, several other companies disclosed that they too needed to restate their previously issued financial statements due to problems with their lease accounting. Because of all the activity, and following a request from the AICPA to provide further guidance on the issues surrounding lease accounting, the SEC issued a letter in February 2005 explaining its position. That letter caused many more companies to review their lease accounting and decide that their financial statements also needed to be restated (Rapoport, 2005).

The majority of the lease accounting restatements were reported in the first few months of 2005, and during that time the business press published a variety of articles on the topic (e.g., Byrnes and Sager, 2005; Gullapalli, 2005; Hughes, 2005; Jones and Gibson, 2005; and Spielberg, 2005a,b). The reactions of analysts quoted in the articles are wide-ranging. Some expressed concern that the lease restatements were simply one more example of how companies were not following GAAP and were using accounting tricks to manage their earnings. For example, one expert stated that the restatements expose "a game that has been played for decades" (Jones and Gibson, 2005, C3), another said that the restatements "raise questions about the companies' financial expertise" (Smith, 2005, 3B), and another added that the restatements "should give investors pause that accounting statements were even less accurate before than anyone imagined" (Smith, 2005, 3B). However, not all analysts agreed that the improper lease accounting was serious enough to merit concern or had been done intentionally. One stated that he did not believe that this was "an attempt to puff up profits" (Byrnes and Sager, 2005, 11); another added that he "did not believe the magnitude of the potential restatements warrants alarm" (Spielberg, 2005a, 59), while another said that, "Technically speaking, this lease issue is not really a big [deal]" (Spielberg, 2005b, 11). …

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