Originally published in Shopping Center Business, August 2005,
© 2005 France Publications, Inc. Atlanta, Georgia

In recent years, businesses such as WorldCom and Enron have become synonymous with corporate malfeasance and questionable accounting practices. In the midst of such infamous cases of corporate wrongdoing, hundreds of well-intentioned retail and restaurant companies have been similarly labeled by federal regulators as engaging in questionable accounting because of the way they have been accounting for leases.

On February 7, 2005, the staff of the Securities and Exchange Commission (SEC) issued a public letter clarifying the application of generally accepted accounting principles (GAAP) to lease accounting. According to the new statement, many public companies have been misapplying GAAP for nearly 30 years with the approval of independent auditors and without comment by the SEC.

The letter expressed the staff’s views concerning the application of GAAP to: amortization of leasehold improvements, rent holidays, and landlord/tenant incentives. The letter challenged long held and generally accepted industry practice and prompted financial statement restatements by many well-known public companies, mostly within the retail and restaurant industries. Combined with the recent effective date for Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404), the SEC staff’s position has complicated or frustrated many companies’ ability to provide a "clean" report on the effectiveness of internal control over financial reporting.

AMORTIZATION OF LEASEHOLD IMPROVEMENTS

Some companies followed a practice of amortizing leasehold improvements over a period that includes lease renewal options. The SEC staff recently clarified that it is more appropriate, and an "error" not to amortize the improvements over the "shorter of their economic lives or the lease terms." The SEC staff "believes that amortizing leasehold improvements over a period that includes assumption of lease renewals is only appropriate when the renewals have been determined to be ‘reasonably assured.’" This clarification is based on the interpretation of a rule indicating that a renewal period is reasonably assured and should be considered part of the lease term only when failure to renew a lease imposes a penalty on the lessee. According to the same guidance, lessees that are unwilling to incur significant direct or indirect costs in order to relocate leasehold improvements may thereby be subject to a penalty.

If lease renewal is reasonably assured, then the lease term used to determine the appropriate lease classification, compute periodic rental expense, and amortize leasehold improvements should include the periods of expected renewal. On the other hand, if lease renewal is not reasonably assured, then amortization of the leasehold improvements should be over the shorter of the asset’s economic life or the lease term, excluding renewal periods. To alleviate uncertainty, all facts and circumstances should be considered at lease signing and companies should establish an accounting policy that is applied consistently across similar transactions.

What do retail building owners and their tenants need to do in order to comply with this new clarification? Many retailers already have a longstanding policy to assign depreciable lives based on the underlying lease term, or the asset’s estimated useful life, whichever is shorter. For example, if the original lease term is 5 years with a 2-year renewal and the useful life is 15 years, the depreciation period would be either 5 years or 7 years; the latter true if the lease option is "reasonably assured." According to the SEC, to use any other measure would effectively understate the recorded depreciation expense. Among others, well-known retailers Rite Aid Corporation and Jos. A. Bank Clothiers, Inc. have already restated for leasehold improvements, and many more businesses are working on such changes.

RENT HOLIDAYS

It is common for retail and restaurant companies to take possession of a property in advance of the commencement of rent payments for the purpose of constructing tenant improvements (TIs). The lease may contain a period of time during which the tenant has the right to occupy the space but pays no rent or a reduced rate. These "rent holidays" can provide the tenant time to build-out the space to its specifications, adding, restaurant fixtures, coffee bars, retail shelves and other equipment. Although the tenant may take a holiday from making rent payments during this build-out period, the SEC staff believes that under GAAP, the tenant should expense the costs of the lease during the rent holiday. The staff concluded that it is inappropriate to suspend recognition of rental expense during a rent holiday. Rather, rent expense of an operating lease should be recognized straight-line (or, unusually, on another "systematic and rational" basis) over the lease term, including any rent holiday period. Accordingly, when the terms of a lease provide for free rent, the tenant should consider recording straight-line rent expense beginning on the date when the tenant takes possession or control of the property, rather than at commencement of operations or rental payments. For some high-end retailers like Ethan Allen Interiors Inc., possession can begin as many as 12 months before the rent commencement date.

LANDLORD/TENANT INCENTIVES

As an inducement to occupy, a landlord will sometimes pay the tenant an amount intended to reimburse for the cost, or a portion of the cost, of leasehold improvements. Some tenants net the funds received from the landlord against the amounts recorded as TIs. Tenants that have netted funds have also reflected the receipt of the funds as a reduction of capital expenditure outflows, an investing activity, on its statement of cash flows. In its letter, the SEC staff clarified that:

  • Improvements made by a tenant that are funded by the landlord generally should be recorded as leasehold improvement assets, and amortized over the shorter of the economic useful life or the lease term;
  • The funds received should be recorded as deferred rent and amortized as reductions to lease expense over the lease term; and
  • The incentive payment should be recorded as an operating activity in the statement of cash flows. The acquisition of leasehold improvements for cash is an investing activity.

In a March 16, 2005 filing with the SEC, the restaurant chain Bertucci’s Corporation noted that it historically "recorded tenant improvement allowances provided by landlords, including improvements funded by landlord incentives as well as allowances under operating leases, as a reduction of the cost of the leasehold improvements." After the SEC letter of February 7th, Bertucci’s decided to "record tenant improvement allowances as an obligation to be amortized over the lease term, rather than netting those allowances against the cost of leasehold improvements."

The SEC staff recognized that the issue of determining whether TIs are assets of the tenant or the landlord may require significant judgment and companies will be pressed to make some tough decisions.

RESTATEMENT OF FINANCIAL STATEMENTS; IMPACT ON SOX 404 REPORTS

Since early 2005, various reports estimate that more than 200 public companies — including companies like Abercrombie & Fitch Co., Toys ‘R’ Us Inc., Kohls Corp., Cingular Wireless LLC, Gap Inc., and McDonald’s Corp. — have altered their treatment of lease accounting to conform to the SEC staff’s position. Particularly troubling for these businesses, each of the "Big Four" accounting firms had previously reviewed and agreed with their historical treatment of lease accounting. Because the SEC cast doubt on whether standard industry practice was consistent with GAAP, many of these same companies were forced to reexamine whether its internal control over financial reporting was effective. The timing of the SEC letter couldn’t have been worse for many companies whose first SOX 404 compliance deadline was in mid- March 2005. It was too late to fix the problem before the end of the year and too late to resolve issues with the independent auditors before the accelerated SEC filing deadline for the Form 10-K annual report.

ASSESSMENT OF INTERNAL CONTROL OVER FINANCIAL REPORTING

Business managers and auditors both need to exercise professional judgment in determining whether a restatement is indicative of a material weakness of internal control over financial reporting. As illustrated by Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2 (AS 2), restatements of previously issued financial statements or the auditor’s identification of a material misstatement is a strong indicator that a material weakness in internal control over financial reporting exists. In situations where financial statements reflect an adjustment for correction of an error, the company and its auditors may evaluate the specific circumstances to determine if a material weakness exists as of the assessment date.

A company’s conclusion that it has a material weakness in internal control over financial reporting greatly depends on the magnitude of the correction (analysis performed under SEC Staff Accounting Bulletin No. 99 – Materiality) and a determination by the party that first identified the error — the company, an independent auditor or the SEC. In some situations, it will be relatively clear that the company has a material weakness in its internal control over financial reporting. Obvious signs of a problem include cases where the company’s controls did not identify the accounting error, the materiality of the amounts involved required the restatement of previously issued financial statements, and the underlying control deficiency was not remediated before year-end. In other cases, both the company and its auditor will need to exercise professional judgment to conclude that no material weakness exists. Companies make a number of arguments as to why a restatement for lease accounting should not be viewed as a material weakness in internal control over financial reporting. Some of these claims include:

  • The impact of the restatement on the periods restated was an immaterial event if amortized over the full restatement period.
  • The restatement does not include a net cash flow change.
  • A company may exercise professional judgment to conclude that a restatement is only a "strong indicator" of, and not actually, a material weakness. Commentary to PCAOB AS 2 highlights auditors’ ability to exercise professional judgment in similar situations.
  • Some companies and public auditors do not believe the staff’s letter of February 7th is firmly supported by accounting literature, particularly the concept that pre-occupancy leasehold buildouts always constitute "rent."

WHAT’S NEXT FOR THE RETAIL INDUSTRY

The SEC’s lease accounting clarification and the resulting industry response may actually cause confusion in the market and undermine the value of SOX 404. Historically, reporting companies have placed great importance on a clean audit opinion from its independent auditors. Companies recognize that an adverse opinion carries a stigma and often has a negative effect on its image with the investing public. In the future, it will be more difficult for the investing public to differentiate between companies that truly have a material weakness in internal control over financial reporting, and those that would otherwise receive a clean opinion, but for "clarification" of GAAP.

It appears that the market already understands this issue. Few companies that restated financials or disclosed a material weakness based on lease accounting experienced a material decrease in stock price. Nonetheless, one has to wonder whether this is what Congress had in mind when creating the SOX 404 review and attestation process.

Given the endless parade of new regulations coming from the federal government, it is often an uphill battle for companies to ensure a clean financial report. Retail tenants and landlords need to make sure they have strong internal controls and are on top of, and adjusting for, each guideline and regulation the government throws their way. With more scandal-plagued companies continuing to draw headlines and legislators responding with more regulation, the recent SEC letter is surely not the last adaptation of GAAP companies will be expected to comply. However, good planning and awareness of new rules on the horizon should give alert businesses a solid footing.

John Saia is a California-based attorney with DLA Piper Rudnick Gray Cary US LLP and member of the firm’s Public Company and Corporate Governance Group. From 1998 to 2004, Saia was a senior attorney with the Division of Corporation Finance at the Securities and Exchange Commission in Washington, D.C.

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.