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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Mar 31

Written by: Jack Ciesielski
3/31/2005 8:59 AM 

That's the question to be asked. (And it has been asked - many times.) If anywhere, I think it could occur in the industrial, health care and information technology sectors. But I don't have a strong conviction that it must happen. Let me explain why.

Think about the nature of the restatements: the three kinds of leasing errors described in the SEC's February 7 letter to the AICPA run the best chance of occurring in industries where 1) there are leasehold improvement on top of the property being leased, 2) there can be concessions from the landlord to the lessee for the cost of leasehold improvements and 3) there may be a rent payment schedule that differs from the straight-line recognition of rent expense.

The industries that have been most affected by the restatement blitz have been the restaurant and retail industries, and to a lesser degree, the (wireless) cellular tower companies. If there are three trip wires to trigger a lease accounting restatement, these industries face the best chance of stumbling on at least one of them. They're asset-intensive businesses, often financed by operating leases; but more frequently than other industries, they have leasehold improvements on top of property leased. That's not as common in other industries that make use of operating leases. For instance, airlines are notorious for using operating leases for aircraft - but they don't have leasehold improvements to the airplanes. Likewise, hospitals lease plenty of heavy medical equipment - but you don't see leasehold improvements stuck onto an MRI unit. Retailers, restaurants and cell tower companies are a bit unique this way - they lease real property, and put something on top of it. That increases their chances of getting their lease accounting wrong.

I know, I know - I've pointed out a few strays from time to time. Like Heritage Commerce Corporation, Powell Industries and Siebel Systems. Like everyone else, I've been curious to see how widespread this trend could become, and stayed alert for the unusual restaters. Now I think these firms were simply outliers and not harbingers of new trends.

We did a little screening with the S&P Research Insight database to see what other industries might be affected. For all the firms on the NYSE, ASE and NASDAQ, the annual rental expense (for operating leases) in the most recent year was multiplied by a factor of 8 - an old standby rule of thumb for estimating the "buried-debt effect" of operating leases on a firm's balance sheet. Then the result was divided by each firm's total assets to see the significance of off-balance sheet operating assets to the firm's asset base. The higher the result, the more dependent would be the firm on its off-balance sheet assets - and the more likely it would have multiple lease contracts, increasing its vulnerability to a lease accounting restatement.

The results: there were 251 firms in the universe where the "8x rentals" amounted to 50% or more of the firm's total assets. Below, the breakdown by sector:




















8x Rents/Assets (Avg.)

No. of Firms

Materials

189%

3

Consumer Discretionary

130%

99

Industrials


108%

39

Telecommunication Services

100%

7

Health Care

89%

37

Information Technology


82%

55

Financials

72%

5

Consumer Staples

67%

5

Energy


62%

1

251


[Yes, I am HTML-challenged. We'll both have to live with it.]

While the materials sector showed promise in terms of lease-dependency, notice it was filled with only three companies - put them in the outlier category and not trend-setters.

The consumer discretionary sector pretty much confirms that the test was a good one. Why? Because 59 of the firms were retailers, and another 28 were restaurants - where most of the action has been, so far. The category made up nearly 40% of all the results, the single biggest presence in the results.

The industrials, health care, and information technology sectors all showed significant lease-dependence and were broadly represented in their sectors. That suggests that lease restatements could occur in those sectors as well - but do the kinds of property they lease contain the three trip wires that have been present in the restaurant, retail and cell tower industries? There's no way to tell from this test: the dollar amount of rental expense doesn't say much about the nature of the assets being leased.

The "rent escalation" issue could occur in just about any kind of lease, any industry. But if it's the only lease foul-up that a company finds, it might not be material enough for 'fessing up. If the other two trip wires are present, it increases the chances of a mea culpa because there are more opportunities for dollar amounts of errors to cross the threshold of materiality. The players in the industrials, health care, and information technology sectors don't set off my bells as being big users of real property with improvements stacked on it - but if there are firms within those sectors that fit that prescription, we could see lease restatements in those groups. If all their leases pertain to discrete equipment, with only exposure to the rent escalation issue, the probability of lease restatements decreases. So there you have it: plenty of leasing going on in those sectors, but not necessarily of the kind generating restatements so far. If we start seeing a couple restatements emerge in those sectors, I'd believe the epidemic still has some steam. But given that most companies have completed their year end audits and internal control reviews, so if they don't start showing soon, the epidemic may be confined. [One exception: many technology firms have fiscal year ends, not calendar year ends. We may have to wait a little longer to see if they're in the clear.]

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