What Do the New FASB Rules for Leases Mean for Restaurants?
Leasing guidance as we know it has been replaced. In February 2016, the Financial Accounting Standards Board (FASB) issued new guidance on lease accounting, Accounting Standards Update No. 2016-02 (the “ASU”). While the intent of the ASU is to provide greater transparency regarding leasing arrangements, the most significant impact of this new guidance is to move all leases onto the balance sheet. This can have a significant impact on the way your company’s financial statements are reported. Are you prepared for those impacts and what it takes to be compliant?
While the ASU impacts the way leases are accounted for in all industries, for some in the restaurant industry, the changes may be especially signifi cant. What do restaurant operators need to focus on in relation to this new standard? They will need to take action in each of the following three ways:
1. Assess the Volume of Existing Leases. Take inventory of the leases maintained by the company. Multi-unit restaurant operators may have hundreds of leases to assess. This will require time and resources to evaluate, as well as to implement the new processes and policies. Understand which agreements have lease components. This could include the leasing of equipment, software, vehicles, real estate property, etc. Determining the volume of existing leases that need to be evaluated will be the first step in establishing the scope of work that needs to be addressed and will help management decide whether it should outsource evaluation of existing leases. Many restaurant entities, especially those with a larger volume of leases, may benefit significantly during transition from adoption of several available practical expedients outlined in the ASU.
2. Gather the Data Needed for Lease Calculations and Determine Accounting Policies. Collect information that will be needed for the lease calculations, and may include items such as the economic life of leased assets, the fair value of the underlying assets, lease payments and lease terms, initial direct costs, and appropriate discount rates. A number of accounting policy determinations also will need to be made, which will impact lease calculations, both during transition for existing leases and in implementation for new leases and any lease modifications. Certain practical expedients will need to be adopted as accounting policies. Management will need to carefully consider practical expedients it may wish to adopt, which can save signifi cant amounts of time and manpower. This includes practical expedients relating to the election not to reassess expired and expiring leases, and the election to not reassess lease classifications. Determine how the company will handle option periods, which may include resolving what is considered to be “reasonably certain” under the ASU.
3. Understand the Impacts on Financial Statements and Other Agreements. Bringing leases onto the balance sheet increases assets and liabilities and could impact covenants with lenders or others. For example, including leases on the balance sheet will increase the total debt shown, thus modifying leverage ratios. Higher levels of disclosures will require organizations to identify the nature of leasing transactions, the lease’s rights and obligations, assumptions and estimates used by management, and a summary of maturities. It is also critical to understand the potential impact on covenant calculations. New leases that are determined to be operating leases likely will increase fixed asset balances, which may have an impact on capital expenditure covenants. Lease classification, which affects how the related lease costs are reported, will need to be evaluated to determine the impact on how earnings are reported under these agreements. Changes to categorization of a lease could affect EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), which is used in many agreements. Lease related costs associated with leases classified as operating leases will continue to be expensed through lease cost expense. Operating lease costs include amortization of the right of use asset as well as interest related to the lease liability. In short, lease costs associated with operating leases will be included in the determination of EBITDA. On the other hand, lease costs associated with finance leases (formally capital leases) are not included in the determination of EBITDA, and instead are reported separately as amortization and interest expense.
Certain agreements may also include components that need to be accounted for separately as leases. For example, a company may have a service agreement relating to its phone system, where the phone equipment is included as a separate component of the service agreement for the phone service. If the portion of the service agreement related to the use of the phone equipment qualifies as a lease, then a right-of-use asset and a lease obligation related to the phone equipment will need to be recorded regardless of whether the lease is classified as an operating lease or as a finance lease. In the past, the balance sheet impacts resulting from lease classification were more significant and operating leases generally were considered to be more advantageous because the related right-of-use assets and lease obligations were not included on the balance sheet. Another consideration of this type of situation would be the potential impact of the lease classification on EBITDA. Classification of the phone equipment lease as a finance lease could be advantageous based on exclusion of the related lease costs from the determination of EBITDA. Discussions should be had upfront with lenders relating to this standard to ensure that there is no confusion once this standard is in place.