Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest


Restaurants Serve Up Restatements: More Scrutiny of Leases Is Leading Some Chains To Trim Their Past Profits



They know their way around the kitchen. Sometimes they aren't so good at keeping track of the rent money.

More than a handful of publicly traded restaurant chains recently have said they will restate past earnings to get a better grip on the costs of their restaurant leases. While the rash of planned restatements has some accounting critics contending the companies have been cooking more than just dinner, industry executives say the problem boils down to a simple, common error and that they never intended to deceive.

Lease accounting is routine, so it is perhaps unusual for a clutch of companies in a single industry to simultaneously discover a problem. Getting the accounting right is particularly important for restaurant chains, because they tend to have widespread leased operations and often have a mix of franchised and company-owned stores.

The problem stems from the way most property (and equipment) leases cover a specific number of years -- the so-called primary term -- as well as a renewal period, known as the option term. In some cases, companies were calculating their lease expense for the primary term but depreciating over both the primary and option terms, which resulted in understating the total cost of the lease and thus boosted earnings.

That is what happened at CKE Restaurants Inc., owner of the Hardee's and Carl's Jr. chains. "The problem was that the two methods needed to be consistent," says Theodore Abajian, CKE's chief financial officer. Correcting the error at CKE reduced earnings by nine cents a share in fiscal 2002, nine cents a share in fiscal 2003 and 10 cents a share in fiscal 2004. For fiscal 2004, which ended in January 2004, the company posted a loss of 88 cents a share on continuing operations after the adjustment.

CKE now uses the shorter, primary lease terms for calculating both lease expense and depreciation. The change increases depreciation annually, which in turn decreases total assets.

Mr. Abajian says the company discovered lease problems while reviewing its Sarbanes-Oxley compliance, referring to the 2002 legislation that mandated improved corporate governance.

Lease accounting has bedeviled a range of restaurant companies, some of which had to restate past years' earnings.
  Decrease In
Company/Brands Total Earnings Per Share Total Assets
CKE Restaurants/ Hardee's, Carl's Jr. 28 cents $30.2 million
Jack In The Box/ Jack In The Box 26 cents $23.7 million
Brinker International/ Chili's, Macaroni Grill 12 cents $15.7 million
Darden Restaurants/ Red Lobster, Olive Garden 10 cents $74 million
Ruby Tuesday/ Ruby Tuesday 7 cents none
Applebee's International/ Applebee's To disclose Feb. 9
Krispy Kreme Doughnuts/ Krispy Kreme Review ongoing
Rubio's Restaurants/ Rubio's To be announced
Source: the companies


Indeed, Mr. Abajian's experience and others' suggest the problem has been around for years and is now only coming to light as companies take another hard look at their books. The stock prices of the restaurant companies restating have remained stable, however, suggesting investors are pleased to see the firms finally get a grip on lease accounting.

Basic accounting rules haven't changed, says Mike Lofing, a senior research analyst at Glass, Lewis & Co., a San Francisco firm that focuses on accounting and governance and caters to institutional investors. "You would have hoped all these people doing this would have covered it in college."

The flurry of restatements exposes "a game that has been played for decades," adds Edward Ketz, professor of accounting at Penn State University and author of "Hidden Financial Risk," a 2003 book.

Reducing lease expense gives the appearance that liabilities are lower than they are, Mr. Ketz says. That, in turn, can permit companies to increase leverage in other ways, such as borrowing.

When CKE announced its restatement in early November, it triggered reviews by at least a dozen other restaurant-chain operators. The resulting adjustments to earnings, some of which are estimates at this point, range from as little as $16 million for Brinker International Inc., operator of Chili's, to $74 million at Darden Restaurants Inc., which operates Red Lobster, Olive Garden and other chains.

Any restatements from the companies are likely to result in noncash financial charges. None of the adjustments threaten liquidity at the businesses and, in most cases, managers are restating past years' earnings rather than taking the hit to current ones. Regulators have been mum.

Not all companies are finding problems. Fast-food goliath Yum Brands Inc., operator of KFC and Taco Bell, looked over its books and concluded no restatements are needed. Pizza franchiser Papa John's International Inc. concluded the same.

The restatements have once again, however, put auditors on the spot. Thomas Fitzgerald, spokesman for KPMG LLP, the auditor for CKE, says the "adjustment involves an isolated number of companies in the industry." He declined to comment on what was behind CKE's changes or discuss KPMG's role in similar adjustments that its other clients were making.

Among other companies, Applebee's International Inc. said it will restate earnings because of the lease issue. Its auditor is Deloitte & Touche LLP.

Jack in the Box Inc. announced changes dating back to 2002, which would require a 26-cent adjustment to per-share earnings and a $23.7 million reduction in retained earnings over three years. Retained earnings are accumulated profits that haven't been paid out as dividends. Company spokesman Brian Luscomb says the hamburger chain investigated its lease accounting after management learned of CKE's adjustments.

McDonald's Corp., whose auditor is Ernst & Young, says it will modify its lease accounting so that it will recognize certain rent expenses more quickly. But the hamburger giant doesn't expect the change to significantly affect its balance sheet or net income and doesn't plan to restate past results.



  1. Explain the basic issue discussed here.
    Ans: The problem is explained in the article as follows:

    "The problem stems from the way most property (and equipment) leases cover a specific number of years -- the so-called primary term -- as well as a renewal period, known as the option term. In some cases, companies were calculating their lease expense for the primary term but depreciating over both the primary and option terms, which resulted in understating the total cost of the lease and thus boosted earnings."

    In a capital lease, there is an obligation on the part of the lessee to make payments to the lessor over a number of years. This constitutes an obligation. Properly capitalized, this constitutes the capital lease liability. On the assets side, there is a corresponding lease asset. This lease asset, obviously has to be depreciated, just like an asset that the company has purchased in a more traditional way. If we assume that the lease is acquired at market value, then there should be no incremental value to stockholders. (This would be a conservative accounting treatment -- in practice, the lease might increase or decrease the market value of equity.) Usually, the actual payment would equal the sum of the "depreciation" plus the "interest payment" on the "liability." Hence, from one year to the next, the reduction in the lease liability would be just balanced by the amount of the depreciation, so that the lease liability would equal the lease asset value.

    Of course, over time, the lease might actually constitute something valuable to equityholders, especially if current lease terms are more onerous than the ones that the company obtained when the lease contract was signed. This, however, is not the issue here.

    Rather, going back to the "depreciation," what transpired was the the firm depreciated the lease asset more slowly than it should have -- specifically, it used the primary term, as well as the option term to depreciate the lease. Consequently, it looked like the lease was adding value over time, independent of whether lease terms were becoming more or less onerous over time.