Restaurants and Their Bankers Need to Come to the Table
New Lease Accounting Rules May Impact Lending
For restaurant owners, leasing space and equipment has always been a cost-effective way to do business. Startups and smaller restaurants especially have found leasing helpful in spreading costs over many years and enabling quick upgrades when equipment becomes outdated.
But trouble is on the menu in the form of new accounting rules governing financial reporting of lease obligations, and restaurant owners are wise to be proactive in preparing for the change. That may mean meeting with lenders in order to redefine loan covenants that make sense. That’s a short-order recommendation – the compliance period is now.
The Financial Accounting Standards Board (FASB), which sets the rules for accounting practices in the United States, released an update in 2016 that changed the rules governing accounting for leases. The new standard was aimed at greater transparency and aligning U.S. accounting standards with international standards. For private companies, the new standard will become effective for fiscal years beginning after December 15, 2020. The compliance period has already started for public companies.
The most important impact of the new rules is the shifting of lease obligations onto companies’ balance sheets as assets and liabilities.
Previously, lease obligations were accounted for “above the EBITDA line,” which refers to Earnings Before Interest, Taxes, Depreciation and Amortization. This means lease payments were categorized as operating expenses. Now, since lease obligations appear as assets and liabilities, they are “below the line,” which is where interest and depreciation appear. The EBITDA line is the critical calculation that bankers look at when determining whether to lend you money.
When a lease is put on the books, it appears as an asset because it represents the right to use the building space or the equipment you are leasing. But it also shows up as a liability to offset that asset, and the liability is defined as the payments you have agreed to make on the lease. As a liability, the lease is characterized as debt.
Isn’t this just moving numbers around on the plate?
Maybe nothing has changed in the way you do business, but your bank is going to see a lot more debt on your balance sheet than it did previously. Unfortunately, that may put you outside your loan covenants.
You’re probably thinking, “But this isn’t my fault. It’s FASB’s fault.” You would be right. But FASB makes the rules that govern accounting practices, and banks tend to follow those rules so that loans can be evaluated against industry standards. This new rule is causing lenders to re-examine their calculations and come up with new methods of determining covenants for the loans they make to restaurant owners.
What should restaurant owners do?
The change in lease accounting rules will likely affect all restaurant owners, but the heaviest impact will fall on those who lease more than their peers.
Larger organizations often lease most of their buildings and real estate, whereas smaller restaurant owners will lease both space and kitchen equipment. A startup or small restaurant usually doesn’t have the $150,000 it takes to outfit a commercial kitchen and furnish a dining room, so leasing and spreading the cost out over several years makes sense.
Owners should take several steps to get ahead of the curve on this accounting change:
- Assess what the impact will be on your business by looking at all your lease obligations, as well as your bank loans and covenants. If you need help, call us for an assessment.
- Once you understand what your current obligations are, meet with your banker and figure out what to do together. It’s a lot better to work on this cooperatively than to just wait for a letter from the bank.
- Work with us to revisit your leasing strategy. With 100% bonus depreciation, thanks to the Tax Cuts and Jobs Act of 2017, buying equipment may be a good option for some restaurant owners who currently lease. But you need to understand the tax ramifications first.
Don’t let the change in lease accounting rules give you heartburn. Call us today for help in assessing how your business will be affected.