Many restaurants rely on leasing to acquire essential assets, from physical space and furniture to kitchen and bar equipment to point-of-sale (POS) systems. If your business has a substantial number of leases, be aware that new accounting rules — which bring most leases onto the balance sheet — may have a significant impact on your financial statements. These rules apply to all businesses that report their financial results in accordance with U.S. Generally Accepted Accounting Principles (GAAP).
Originally, the new rules were set to take effect in 2020 for privately -held companies, but luckily the Financial Accounting Standards Board (FASB) recently voted unanimously to delay the effective date to 2021. Although the FASB will provide an opportunity for public comment before finalizing its proposal, the delay is expected to be well received.
The one-year reprieve provides some breathing room for businesses concerned about the amount of legwork required to comply with the new rules. But if you have not begun the implementation process, it is a good idea to get started as soon as possible.
Under current accounting rules, leases are classified as either “capital” leases, which generally transfer ownership of the underlying asset to the lessee at the end of the term, or “operating” leases, which transfer only the right to use the asset during the term. The former are reported on the lessee’s balance sheet, while the latter are treated as “off-balance-sheet” transactions.
The new rules will require lessees to report all leases on their balance sheets, with an exception for short-term leases (those with a term of 12 months or less), which can clearly change the appearance of balance sheets in certain instances. This means recording a “right-of-use” (ROU) asset and a corresponding liability to make lease payments. Initially, both the asset and liability will be measured at the present value of minimum lease payments to be made over the lease term, with certain adjustments. The new rules preserve the distinction between operating and capital (or “finance”) leases. The distinction determines the way lease costs are expensed on the income statement.
At 300-plus pages, the new rules are complex and far-reaching. But there are a few key issues of particular importance to restaurants:
- Increased Debt
By adding liabilities to your restaurant’s books, the new rules may affect key performance metrics or cause technical violations of debt covenants (depending on how “debt” is defined). Accounting changes do not affect the underlying economics of your lease transactions, but it is important to discuss their impact on your financial reporting with investors, lenders and creditors, especially to avoid unintended consequences.
- Renewal Options
Selecting the correct lease term will be critical in determining whether a lease is short or long term and calculating future lease payments. Under the new rules, the term includes the initial non-cancelable period plus any renewal options that you are reasonably certain to exercise. In assessing the likelihood of renewal, you must consider all relevant economic incentives, such as your investment in leasehold improvements and the cost of relocating.
- Embedded Leases
To comply with the new rule, you will need to review not only traditional leases, but also other types of contracts that convey “the right to control [an identified asset] for a period of time in exchange for consideration.” Suppose, for example, that your POS system vendor provides “free” hardware in connection with a five-year contract to use its transaction processing services. You may be required to allocate the consideration between the contract’s lease and non-lease components and record the former on your balance sheet.
Depending on how these issues affect your business, you may want to revisit your lease versus buy decisions, renegotiate debt covenants and consider the implications of renewal options in your leases.
Prep Time is Crucial
To ensure a smooth transition to the new lease accounting rules, leave plenty of time to identify all your lease. Gather the data you need to meet new reporting and disclosure requirements and ensure that you have systems and processes in place to track and report leasing activity going forward. You will also need time to evaluate the impact of the new rules on your financial statements and discuss the potential ramifications with investors, lenders and other stakeholders.
For more information, contact Christopher Georgiou at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Restaurant Group.