Magazine article The CPA Journal

Recent Controversies in Accounting for Operating Leases and Leasehold Improvements

Magazine article The CPA Journal

Recent Controversies in Accounting for Operating Leases and Leasehold Improvements

Article excerpt

As if the requirements imposed by the Sarbanes-Oxley Act (SOA) and the tough economic climate aren't enough, corporate accountants are being prodded to reexamine their accounting practices with respect to operating leases. Beginning in November 2004, a small number of companies began restating their financial statements due to nonconformity with current lease standards. These restatements accelerated in February 2005 after a letter from then-SEC Chief Accountant Donald T. Nicolaisen to the AICPA was published on the SEC's website. By the end of the month, more than 80 companies had either restated or were determining the amount of a restatement due to problems associated with their lease accounting and accounting for incentives related to leasehold improvements.

To date, the restatements have been concentrated in three industries that rely heavily on leased facilities and equipment: restaurants, retail, and cellular telephone towers. The entities involved have ranged from small-capitalization companies like Smith & Wollensky to such large-capitalization companies as Starbucks and Target. The restatements have focused on three areas: the amortization of leasehold improvements, the recognition of rent expense when the lease agreement contains rent holidays, and incentives related to leasehold improvements.

One set of restatements appears to have resulted from companies amortizing leasehold improvements over a period exceeding the lease term of the property containing the leasehold improvements. Consistent with SFAS 13, Accounting for Leases, the Office of the Chief Accountant stressed that companies must amortize leasehold improvements over the shorter of the economic life of the leasehold improvements or the lease term. In cases where the lessee has the right to renew the lease for additional periods (common in many of these arrangements), the lease term for the purpose of calculating amortization of the capitalized cost of the leasehold improvements should be extended only if it is "reasonably assured" that the lessee will renew the lease.

SFAS 98 provides additional guidance for lessees in determining if a renewal is reasonably assured. If the failure to renew would impose a penalty on the lessee, if there are renewal periods prior to a bargain purchase option exercise date, or if the lease renews at the lessor's discretion, then the lease term should include the renewal periods. An additional case in which the renewal may be reasonably assured involves instances where the lessee, either directly or indirectly, guarantees the lessor's debt related to the property. In this case, the lease term should include all ordinary renewal periods during the guarantee period.

The second situation cited by the SEC involves operating leases that contain rent holidays (i.e., periods where rent is waived or discounted). Some companies evidently have mistakenly failed to recognize rent expense in periods preceding the commencement date of operations. The SEC has reiterated that recognition of rent expense should begin as soon as the leased property is physically occupied, even if that period includes a build-out phase. Rent expense should be recognized on a straight-line basis over the entire lease term, including periods where no or reduced rent is paid.

The third situation addressed by the SEC involves operating leases where lessees make leasehold improvements to the leased property that are funded, in whole or in part, by landlord incentives or allowances. …

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