Capitalizing Your Kitchen

The new standard did not eliminate the various lease classifications, and the lease classification requirements to determine which class of lease your contract falls under remain relatively unchanged.  Under the new standard, leases are classified as “Finance” or “Operating” leases.  If one of the following are met, the lease is classified as a finance lease:

• The asset will be transferred to the lessee at the end of the lease term, including through purchase option which is reasonably certain to be exercised
• Lease term is for majority of the remaining life of the asset
• Lease obligation is equal to or exceeds the fair value of the asset
• The asset is so specialized in nature that it is not expected to have any alternative use at the end of the lease

If any of the above requirements are met, the lease should be accounted for as a finance lease.  Finance leases will result in different recognition of expense over the lease term, with interest expense and depreciation of the asset.  Lease classification should be evaluated at the beginning of the lease, and only reassessed when the contract is modified or there is a change in the evaluation of whether a purchase option will be exercised.

The new standard provides for an election to not apply the new lease guidance to short-term leases.  A lease is considered short-term if it is for a term of 12 months or less and does not include an option to purchase the asset that the lessee is reasonably certain will be taken.

• Lease Term
  • The lease commencement date, and the date the lease obligation should be calculated and recorded, is the day the asset is made available for use by the lessor. Many restaurants will gain access to the new space to perform the build-out for the new store months before the restaurant is open, and many times, before any lease payments are due under the lease.  Furthermore, the date the space is turned over to the restaurant owner can differ from the date the lease is signed or even the lease commencement date stated in the lease contract.
  • Under accounting standards, the lease obligation and right-of-use asset should be measured and recorded on the date the space was made available to the lessee, regardless of whether any work begins that date or any lease payments are yet due.  The related lease expense should be recorded on a straight-line basis over the lease term, beginning on that commencement date.  Many times, this will lead to lease expense for the store before any payments are made and before any related sales revenue is earned.

• Options to Extend the Term
  • Many restaurant leases will contain provisions to extend the lease for additional terms. If the additional terms are at the election of the lessee, the payments under the additional term will be included only if the lessee is reasonably certain the option will be exercised, and the additional term will be taken.  Due to the volatility of the restaurant industry and the length of lease terms, most restaurants would not include the additional lease term until the lease is nearing the end of its initial term and the restaurant is more certain that the extension period will be used.

• Lease Payments
  In determining the payments to include in the initial lease obligation calculation and the payments to be recorded as lease expense on a straight-line basis over the lease term, the following payments should be considered:

• • Fixed payments and payments dependent on an index or rate – Index or rate effective at the commencement of the lease for similar term as the lease should be used.
  • Amounts received from landlord (e.g., tenant improvement allowance) – Reduces the total payments to include in lease obligation and lease expense.
  • Variable payments (e.g., percentage rent based on sales) – Excluded from lease obligation if payments are variable and contingent upon a future event. Included in lease expense as incurred (e.g. as underlying sales occur).
  • Other charges (e.g., common area maintenance, real estate taxes, and insurance) – Fixed payments are included in the lease obligation unless payment is for other services (“non-lease components”). Variable payments are excluded and expensed as incurred. See Non-Lease Components section for more information on treatment of non-lease component payments included in lease contract.

• Discounting Lease Payments
  Future lease payments required in the lease should be discounted to get to the present value of the future payments.  The rate implicit in the lease should be used, when available.  Many leases do not provide for a rate within the lease contract, in which case the lessee’s incremental borrowing rate should be used.  The standard provides for an accounting policy election for non-public companies to use the risk-free rate at the commencement of the lease, for a term similar to the lease term.

Lease contracts must be analyzed to determine if any non-lease components are included.  Additional goods or services provided under the lease contract, other than the underlying leased asset, are considered non-lease components (e.g., common area maintenance).  Payments should be allocated between the lease and non-lease components, and the payments related to the non-lease component are excluded from the lease obligation and expensed as incurred.

However, to simplify accounting for leases under the new standard, lessees may make an accounting policy election not to separate out the non-lease components.  Any fixed payments for non-lease components would then be included in the lease obligation.

When a lease is amended, the modification should be analyzed to determine if the amendment creates a separate contract or if it is a modification to the existing contract.  If the modification changes the underlying asset leased (e.g. additional space leased), it is likely to be considered a separate lease which would then be measured and recorded on the lease modification date separately from the original lease. If the modification is determined not to be a separate contract, the lease asset and liability are remeasured on the lease modification date, based on the present value of the future payments under the amended terms.

The standard requires modified retrospective application for all leases existing at, and entered into subsequent to, the beginning of the earliest period presented.  If you present comparative statements, this means the new lease standard must be applied to leases at January 1, 2019, for calendar year end companies.

Modified retrospective application means the lease obligation and right-of-use asset are calculated and recorded under the new guidance as of the beginning of the earliest period presented, based on all remaining lease payments due under existing contracts.

The new standard provides for various implementation options to ease the burden of initial implementation.  The following elections may be made:

• Election to not reassess whether a contract contains a lease and not reevaluate lease classification (operating or financing) for contracts existing at time of implementation
• Election to not reassess treatment of initial direct costs (costs paid upfront but allowed to be deferred and expensed over lease term)
• Election to use hindsight in determining lease term (options to extend or purchase)

The elections above must be applied consistently to all leases held by your company.  The various elections will impact when the initial calculation of your current leases is completed under the new standard, time required to invest in gathering details, analyzing leases, calculating lease assets and liabilities; and the total obligation and right-of-use asset recorded.  Understanding the options available will allow you to weigh the benefits and impacts on your financials and resources.

The new lease standard is a major overhaul of accounting for an area that represents a major aspect of a restaurant’s business.  With the effective date coming up soon, it’s important to understand the impact it will have on your business and prepare your company for implementation now. Here are a few tips on getting started on the process:

• Gather all leases and make sure you have the most up-to-date copies, including amendments. Think of other assets which could be impacted, other than your physical restaurant site lease (e.g., equipment leases, auto leases, copier leases).
• Review leases and create a listing of all leases and the key terms, including:
  • Key dates and term – Lease commencement (time asset made available), lease payment commencement, term, option periods, etc.
  • Payments due – Fixed base rent, percentage rent, other variable payments, payments affected by CPI or other index and the relevant rate at commencement
  • Components included in the contract – Are there any non-lease components?
  • Rate implicit in lease, if any, or the discount rate determined
  • Lease determination – operating or financing
• Model the impact on your financials of implementing the lease standard, considering the various elections available.
• Review and discuss with all key stakeholders to understand the impact on your business. With this impacting financial statements, financial ratio covenants, and resources needed to implement and carryout the new standard, the affects should be reviewed from different perspectives to ensure the best options are elected for the business as a whole.  This could impact future leasing decisions, loan agreements, and transactions, so ensuring management, owners, and business partners are aware of the impact is key.