While the new leasing standard overhaul will have a wide range of effects on most entities, it will create significant challenges for entities in the restaurant and hospitality space. For restaurant and hospitality companies with a large portfolio of leases, the new standard will require not only the gathering and summation of existing lease information, but also will significantly affect existing business processes, internal control structures, financial debt covenants and financial metrics.
Issuance & Overview
In 2016, the Financial Accounting Standards Board (FASB) issued its long-awaited standard requiring lessees to recognize all leases with terms greater than 12 months on their balance sheet as lease liabilities with a corresponding right-of-use (ROU) asset. Accounting Standards Update (ASU) 2016-02, Leases (Topic 842), maintains the dual model for lease accounting, requiring leases to be classified as either operating or finance, similar to existing lease guidance. Under the ASU, a lessee will recognize the value of the asset created by the lease as an ROU asset and a corresponding lease liability for the minimum lease payments, discounted at the rate implicit in the lease (if the rate isn’t known, the lessee’s incremental borrowing rate will be used).
When measuring assets and liabilities arising from a lease, a lessee should include payments to be made in optional periods only if the lessee is reasonably certain it will exercise an option to extend the lease or will not exercise an option to terminate the lease. Optional payments to purchase the underlying asset should be included in a similar manner. A lessee will exclude most variable-lease payments in measuring lease assets and lease liabilities, other than those that depend on an index or rate or are, in substance, fixed payments.
Compliance with Debt Covenants
One of the largest concerns related to the new ASU is the effect it will have on key business performance metrics like working capital and earnings before interest, taxes, depreciation and amortization (EBITDA) and the correlating impact on financial reporting covenants. The new standard will have a direct effect on debt compliance for restaurant and hospitality clients, especially those who currently have a large portfolio of operating leases.
As operating leases are now required to be capitalized on the balance sheet as ROU assets with a corresponding lease liability, bank covenants calculated based on liabilities like the current ratio or debt-to-equity ratio will be directly affected, as the resulting increase to both short-term and long-term liabilities will cause an unfavorable impact on both ratios. Although operating leases aren’t technically defined as “debt” within the new ASU, some creditors may categorize them as such, which could dramatically influence some financial ratios like the fixed charge coverage or debt service ratios.
Under the financing lease model, the accretion of lease liabilities is treated as an interest expense; however, under operating leases it’s treated as part of the total lease costs. Accordingly, the classification of the lease will determine the potential add-back for interest expense when calculating EBITDA. It’s essential to review all debt agreements, including covenant requirements, to ensure the adoption of Accounting Standards Codification Topic 842 (ASC 842) won’t result in a potential covenant failure or default event.
Financial Statement Classification
When compared to the current guidance on leases, the new standard will have different reporting requirements and classification for the two different lease types, as shown below:
Under ASC 842
Under Current Guidance (ASC 840)
Due to the differences in the way lease-related assets are treated under both generally accepted accounting principles and tax purposes, deferred tax assets and liabilities may be directly affected. Be sure to read our article for specific information about how tax reform will affect the hospitality industry.
The ASU requires both qualitative and specific quantitative disclosures to help investors and other financial statement users better understand the amount, timing and uncertainty of cash flows arising from leasing activities.
The new guidance is effective for public entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, i.e., January 1, 2019, for a calendar-year entity. All other entities should apply the new guidance for fiscal years beginning after December 15, 2019, i.e., January 1, 2020, for a calendar-year entity, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities.
The ASU allows companies to apply the lease guidance at a portfolio level and elect transition reliefs (termed “practical expedients”); it also provides guidance to help entities meet implementation requirements. Transition reliefs include the ability to:
- Forgo the requirement to review existing contracts for lease arrangements and evaluate lease classification for existing leases
- Forgo the need to identify initial direct costs for leases that commenced before the effective date
- Use hindsight in evaluating lessee options to extend or terminate a lease or purchase the underlying asset
Companies are allowed to elect the modified retrospective approach or the alternative-modified retrospective approach, as detailed below. Full retrospective application isn’t permitted.
Early adopters identified operational challenges in comparable period reporting requirements under a modified retrospective approach. The amendments in ASU 2018-11 create an additional (and optional) transition method whereby an entity initially applies ASC 842 at the adoption date and recognizes a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption without adjusting the comparative periods presented. Prior periods presented would continue under guidance in ASC 840. If elected, a lessee wouldn’t have to measure and recognize leases that expired prior to the effective date, or consider the effects of each modification for leases that were modified more than once during the comparative period presented. This new method would change when an entity would be required to initially apply the new lease standard’s transition requirements; it wouldn’t change how those requirements apply. The amendments don’t change ASC 840’s existing disclosure requirements. If elected, an entity would continue to provide the required ASC 840 disclosures for all prior periods.
The update includes specific transition guidance for sale and leaseback transactions, build-to-suit leases, leveraged leases and amounts previously recognized in accordance with the business combinations guidance for leases.
BKD will continue to monitor various aspects of the new standard (including FASB’s plans to provide educational information), respond to technical inquiries and stage workshops.
Contact Jonathan or your trusted BKD advisor if you have questions.