From the case study, create an argument for the use of


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Apr 05, 2016. From the case study, create an argument for the use of principles-based accounting for leases over rules-based accounting under GAAP, based on the financial statement restatements in the restaurant industry. Provide support for your argument. Assess the materiality of the errors, direction provided by the Securities and Exchange Commission (SEC), and the Sarbanes-Oxley Act (SOX) on the decision by management to restate the financial statements. Indicate the likely impact to stakeholders when financial statements are restated. ATTACHMENT PREVIEW Download attachment Case Study_Lease Restatements_76796.pdf CASE 3.2 Lease Restatements in the Restaurant Industry, 2004–2005 Prior to 1970, most U.S. firms used leasing for short-term needs. A small firm might lease an office, copier, or manufacturing space for one or two years to limit the risk if the business failed. If a larger firm needed expensive equipment or a building, it often financed the asset by borrowing from a bank, using the asset as collateral. No lease accounting rules existed and none were necessary. Firms simply recorded lease expense when they made each month’s rent or lease payment. Beginning in about 1970, U.S. firms realized they could structure long-term lease agreements that were equivalent to buying an asset with debt. A firm might purchase a $50 million building with a $50 million bank loan to be repaid over a 20-year period at $410,000 per month (an effective annual interest rate of about 8%). Instead, the firm might ask its bank to structure the transaction as a $410,000 per month 20-year lease, with the additional stipulation that at the end of 20 years the firm must purchase the building for $1. The firm would also maintain and insure the building. Except for the additional $1 after 20 years, the terms are identical, thus the bank should be indifferent as to whether the transaction is called a loan or a lease. With a lease, however, the firm would not record the building as an asset or record the present value of lease payments as debt. Using the example in the previous paragraph, suppose the firm had $150 million of assets, $50 million of debt, and $100 million of equity prior to the transaction, its debt-to-equity ratio would have been 0.5. With $50 million of added assets and debt, the debt-to-equity ratio would increase to 1.0; with a lease, the ratio would remain at 0.5. Firms began to use leasing as one of the first forms of off-balance sheet financing. Leasing became so common that in November 1976 the newly established Financial Accounting Standards Board (FASB) issued guidance on how to account for leases (Section 840, previously FAS 13). ACS 840 (FAS 13), Accounting for Leases The FASB classified leases into two categories, shorter-term operating leases and longer-term capital leases. For an operating lease, the lessee records lease expense each month when it pays the rent or lease cost. The journal entry is a debit to lease or rent expense and a credit to cash, although as discussed later in this case, in practice the journal entries are more complex. With a capital lease, the lessee records the lease so it is equivalent to buying an asset with debt. Thereafter, the lessee separates lease payments into an interest component and a partial principal repayment. The lessee also depreciates the leased asset over the lease term, as if it bought the asset with borrowed funds. Capital Lease Example Exhibit 1 provides a simple example of a two-year capitalized lease. Typically, capital leases are for much longer periods, but conceptually they are identical to this example. The lessee makes a $10,000 lease payment at the beginning of each month, starting January 1, 2008 (second column). The lessee computes the lease’s present value, which requires a discount rate. FASB’s guidance on accounting for leases requires 1 2 SECTION THREE FINANCIAL REPORTING—U.S. GAAP that the rate be the l…

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