New accounting for leases could make some restaurants’ balance sheets look less appetizing for stakeholders
Sept. 1, 2016 · Authored by Justine Hunter, Nick Bergamo
The restaurant industry is heavy on leases. For publicly traded concepts with location counts ranging from 150 to over 1,000, each dot on the map represents not just one lease but many. Building space is the most obvious, but soda fountains, beer taps, and sometimes even kitchen equipment may all be leased, and all of these arrangements are impacted by a soon-to-be-effective accounting standard.
First, know the new standard isn’t only a matter of translating numbers or keeping your concept’s books up to date. In fact, the new standard brings previously unrecognized assets and liabilities onto the face of the balance sheet, which could have an impact on your business ratios, earnings per share, debt covenants, and other key performance metrics.
Let’s look at a few of the most important considerations related to the new standard for publicly traded restaurants, including what they should be doing now to prepare for implementation.
Issuance and effective dates
Let’s start with some background on the standard: In early 2016, the Financial Accounting Standards Board (FASB) issued an accounting standards update that changed how organizations that follow U.S. generally accepted accounting principles (GAAP) report their leases. The new guidelines are contained in Accounting Standards Codification (ASC) Topic 842, Leases, with conforming changes made throughout the Accounting Standards Codification.
The new accounting standard is effective for fiscal years of public business entities beginning after Dec. 15, 2018, including interim periods within those years and may be adopted early. When adopted it must be applied on a modified retrospective basis, starting with the earliest period presented in a company’s financial statements. This means that even though the standard’s effective date is a ways off, it’s easier to begin accumulating information for accounting under the new standard now so your information for 2017 and 2018 is readily available when you do prepare your 2019 financial statements. What this means to the registrant (you) is tracking two sets of accounting for each lease as early as Jan. 1, 2017 (for calendar year-end reporting entities).
Key terms and distinctions
First and foremost, ASC Topic 842 redefines the term lease, making it generally broader than under legacy guidance (ASC Topic 840). Under the new definition, a contract is (or contains) a lease if it:
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Explicitly or implicitly specifies the use of identified property, plant, or equipment
Grants the customer control of the identified asset for a period of time
Leases are separated into two classes: finance leases (previously called capital leases) and operating leases. Under the new standard, both operating and finance leases must be presented on the balance sheet as a right-of-use (ROU) asset and corresponding lease liability. Under legacy guidance, a lessee with a capital lease recorded a fixed asset under capital lease and corresponding capital lease liability on its balance sheet; under the new guidance it now will record an intangible ROU asset and corresponding lease liability.
As for operating leases, legacy guidance didn’t have any balance sheet impact outside of certain mechanics to straight-line the rent expense and lease incentives. Under the new guidance, lessees will now gross up their balance sheet to include an ROU asset and a lease liability.
The financial statement presentation of the two types of leases also differs, as shown in the table below.
It’s important to revisit all leases (and even some contracts that aren’t leases under legacy guidance, as we’ll cover below) in anticipation of the new standard. Don’t simply assume that former operating leases will remain operating leases, or that former capital leases will become finance leases, or that just a few accounting tweaks will be needed.
The new standard requires a reexamination of all contracts to determine if they’re a lease or contain a lease and to classify all identified leases under the new guidance. However, it’s generally recognized that many capital leases will result in being classified as finance leases and most existing operating leases will retain such classification.
Leases in new places
Looking back at the definition of lease above, consider your contracts, for example, with beverage vendors. These arrangements often include the use of soda fountains, beer taps, or similar equipment. In the restaurant industry, these nontraditional lease arrangements may catch business owners by surprise when ASC Topic 842 takes effect.
Contracts with soda vendors, for example, are often paid based on syrup usage. They essentially provide syrups, but fountains are often included as an incentive or add-on item for “no charge.” Traditionally, these arrangements have allowed restaurants to avoid paying the cost of equipment up front, increasing their cash flow. The syrups come at a slightly higher cost than they otherwise would because the use of the fountain is included.
Under legacy guidance, payments to these vendors would be expensed as incurred; nothing would be capitalized. But because these contracts meet the two criteria for a lease, they could qualify as a lease. (Whether it’s an operating or a finance lease depends on the specifics of the contract.) While the payments for the syrups and sodas are expensed as usual under ASC Topic 842 as nonlease components of the agreement, the lease payments for use of the soda fountain may need to be recognized as an ROU asset on the balance sheet, depending on the terms of the contract.
In this example, the individual cost of the lease and nonlease components is calculated based on a relative stand-alone price basis. Doing so may require some extra legwork — for example, asking the vendor to provide a quote for the fountain lease and the syrups and sodas separately. Alternatively, you could obtain a price quote from the related equipment manufacturer, using it to back into the cost of the equipment under the agreement. This is another good reason to start analyzing the impact of the new guidance now.
Impact
Aside from requiring a potentially significant amount of work from your concept’s accounting department, ASC Topic 842 could change the numbers reflected on your balance sheet, which may alter stakeholders’ perception of your company’s financial strength.
Many companies’ largest concern is the new standard’s impact on key business metrics, including working capital, current ratio, and EBITDA (earnings before interest, taxes, depreciation, and amortization). In some cases, bringing leases onto the balance sheet could change these performance indicators substantially enough to trip debt covenants with lenders or make financing harder to come by. While operating lease liabilities aren’t technically considered debt under U.S. GAAP, some creditors may view them that way. Accordingly, carefully review the provisions of existing agreements, including debt covenants, to ensure recognizing operating lease liabilities following adoption of ASC Topic 842 won’t cause the failure of debt covenants or have other unanticipated consequences.
Deferred tax assets and liabilities may also be impacted. Because lease-related assets and liabilities are recorded differently for GAAP and tax purposes, this change in GAAP could either increase or decrease the size of deferred tax assets and liabilities as well as impact the deferred income tax expense. This won’t actually affect restaurant businesses in terms of cash flow, but it could alter the perceptions of their financial statement users.
In addition, increasing complexity surrounding the accounting for leases may mean public company restaurants need to update related control processes. Because chief financial officers must sign off on the company’s internal controls each year, companies need to be especially deliberate about how they manage these changes leading up until the effective date of the new standard.
Next steps
Even restaurant businesses that aren’t ready to fully implement the guidance yet should have a general sense of how their financial information will change under the new standard. Initiate conversations with lenders now to understand how your covenant calculations will be impacted by the new accounting, keeping in mind the fact that lenders too are still learning their way around the new guidance.
If your business has a significant number of finance leases, look at the potential impact on your earnings per share as well. Because the accounting for finance leases front-loads expenses, these leases could impact what your business reports in earnings. Again, educating and talking with stakeholders early on in the process is an important first step in mitigating the potential impact of applying the new standard. Also, because all leases will now result in lease-related assets and liabilities on the balance sheet, consider whether it’s better to buy versus lease certain assets. Lastly, while it was often advantageous to achieve operating lease classification to avoid recognition of leases on the balance sheet, some view classification as a finance lease as being advantageous under the new guidance because it will generally result in a higher EBITDA than a lease with similar payments classified as an operating lease would.
