Earning Management inRestaurant Industry

By: Evan CuiHao ChenHuijing Hu (Thea)Jialin HuangQiang Chen (Jason)

Agenda

Part 1

Part 2

Part 3

Part 4

Part 5

Intro & Methodology

Accounting Issues

Case Study and Empirical Result

Audit Guideline

Prediction & Conclusion

Introduction

• “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.” 2005, WSJ

Methodology

• Find CAR- How market react to restatement.

• Modified Jones Model – To determine earning quality.

- Obtained Compustat from WRDS

- Filtered the data by industry using SIC

- Regression Using Data Analysis

- Trend Analysis

Accounting Issue: LeaseFeb 7,2005, SEC published a clarification on the application of key issues for lessees:

• The proper amortization period for lease hold improvement;

• Accounting for rent holidays and option period.

To correct errors in lease accounting policy to follow GAAP:

1. Extend the option period: the company will restate its financial statements to recognize rent expense on a straight-line basis over the lease term that includes cancelable option periods ,rent holidays and etc.

2. Depreciation period for lease improvement: the company will restate its financial

statements to recognize rent expense to depreciate leasehold improvements over renewal period or actual useful life if shorter.

Expected DAs Due to Accounting Issue

• For restatement period, Discretionary Accruals should be positive or at least near zero

a) Violation of Issue 1 longer Depreciation period for lease improvements Less Depreciation Expense Higher NI Positive DA.

b) Violation of Issue2 shorter lease termMore Deprecation Expense

Smaller NI Negative DA.c) Normally, Violation of Issue 2 have less impact than issue 1 since it

change depreciation period less Overall Non-Negative DA

• For non –restatement period, namely 2000, 2001 and 2005, Discretionary Accruals approach to zero

Case Introduction

Company name Outback Steakhouse Inc.

Back Yard Burgers Inc.

Applebee’s

Foundation year 1998 1987 1980

Main business Australian-themed American casual dinning restaurant chain

A regional franchise chain of quick serve restaurants

Casual dinner with mainstream American dishes

Scope (2012) Over 1200 locationsin 23 countries

89 locations in the Southern and Midwest United States

Over 2000restaurants operating system wide in the united states

Case RestatementsOutback Steakhouse Inc.

Back Yard Burgers Inc. Applebee’s

Fraud year 2002-2004 2002-2004 2002-2004

Results of restatement on netearnings (In thousands)

2002 Decrease $2855

2002 Decrease $125 2002 Decrease $2500

2003 Decrease $2951

2003 Decrease $100 2003 Increase $800

2004 Decrease $3346

2004 Decrease $150 2004 Increase $1300

Empirical Results For CAR

Explanation for CARs

• All three companies’ CARs are very small, near to 0. It indicates market doesn’t react significantly to financial restatements.

• The violation of GAAP is not intentional.

• The violation does not involved cash flow, it doesn’t hurt investors’ confidence.

Empirical Results From Modified Jones’ Model

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

2000 2001 2002 2003 2004 2005

Discretionary Accruals

Apple Bee's Outback Steak House Back Yard Burgers

Empirical Result For Applebee’s

-0.08

-0.03

0.02

0.07

2000 2001 2002 2003 2004 2005

Discretionary Accruals

Apple Bee's

For 2003 and 2004, it has negative discretionary accruals.

At the same time, the management also made mistakes to overstate the vacation and workers' compensation expense.

Empirical Result For Back Yard Burgers

-0.09

-0.04

0.01

0.06

0.11

2000 2001 2002 2003 2004 2005

Discretionary Accruals

Back Yard Burgers

For 2000 and 2001, the discretionary accruals are positive.

Even before the restatement period, the violation of the GAAP (Lease Issue) also exist, most companies has limited influence, but Back Yard Burgers is an exception.

Empirical Result For Outback Steak House

-0.08

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

2000 2001 2002 2003 2004 2005

Discretionary Accruals

Outback Steak House

For 2002, the total discretionary accrual is negative.

It indicate the company also have other discretionary accruals management, such as overestimate bad debt expense and deferred recognition of impairment loss.

Audit Guideline

• Red Flag 1: If a company signs many new lease contracts and expand its business in a year. The large amounts of new lease contracts increase risk for inappropriate calculation of lease term.

• Audit Procedure:

1. Check documents related to the option period items which is included in lease term.

2. Communicate with management to acknowledge the option period.

3. Make sure lease liability incurred date match lease depreciation expense recognized date.

Audit Guideline

• Red Flag 2: If a company has large amounts of lease improvements, it may raise a red flag for inappropriate amortization of rent expense on leasehold improvements.

• Audit Procedure:

• 1) Check lease contracts related to the improvement items.

• 2) Estimate depreciation expense for lease improvements.

• 3) Compare leased property improvement useful life to benchmark to see if its useful life is reasonable.

Prediction

• Popeye's is continuing to expand its restaurants in the U.S. and worldwide

• The company signs many new lease contracts

• The company has large lease improvements

Conclusion

• Violation of GAAP on lease expense could result in discretionary accruals

• The market reaction to restatement is not very significant, because the violation is not intentional

• Restaurant companies should pay more attention on their accounting methods for operating lease expenses and relevant items

Conclusion

• Violation of GAAP on lease expense could result in discretionary accruals

• The market reaction to restatement is not very significant, because the violation is not intentional

• restaurant companies should pay attention to their accounting methods for operating lease expenses and relevant items

Thank you

Question?