FASB has just given the go-ahead to delay the effective date of the new lease standard for private companies for another year. Now it won’t be applicable until 2021 for calendar year ends. But it is still important to envision what the impact will be to your financial statements. Our earlier blog, “New lease standard: 5 things restaurant owners MUST know now” covered the basics of the new standard. Here, we’ll look at the transition impact that it will have to the restaurant balance sheet.
Currently, many restaurants have a deferred rent liability on their balance sheets. One component of this deferred rent is associated with the accounting for escalating rents and any rent-free months that are provided under the lease. The deferred rent balance is an accumulation of the difference between the actual rent paid each month and the amount that is recognized to record a straight-line rent expense throughout the term of the lease. This amount usually increases in the early part of the lease term before reducing to zero by the end of the term.
The other component of deferred rent for many restaurants is related to allowances provided by landlords in making leasehold improvements to the restaurant space. This is where the landlord bears the cost, or a portion of the cost, for leasehold improvements that need to be made. As the lessee, you are required to reflect this leasehold improvement as an asset with an offsetting amount recorded as deferred rent. This deferred rent is then credited to rent expense over the term of the lease while you recognize an amortization expense associated with the leasehold improvement.
Upon adoption of the new lease standard, a lease liability will be established on your balance sheet based upon the present value of the future lease payments that will be made under the lease. Accordingly, the liabilities on your books will increase as the deferred rent you have recorded. This is based upon the cumulative difference between rent paid and the straight-line rent expense amount. It will be replaced by a liability determined from the future lease payments. This lease liability will also take place of any deferred rent that you reflected for leasehold improvement allowances that were received.
The asset side of the balance sheet will have a different story. While a new right-to-use asset will be recorded based upon the amount used to calculate the lease liability, it will be reduced for any allowances (lease incentives) received. The amounts you spent for the leasehold improvements will be reflected as part of your property and equipment, which is no different than how the leasehold improvement allowances are treated currently.
Assuming you don’t present comparative financial statements, at transition, you will reflect the net effect of recording these additional lease assets and liabilities as an adjustment to the opening balance of retained earnings (or similar equity account). If you present comparative financial statements, you have the option of reflecting the amounts under the new lease standard within the comparative periods presented or just include the impact in the period of adoption. If you measure your leases under the new standard in comparative periods, equity will be adjusted for the net effect as of the beginning of the earliest period presented.
While it looks like you’ll now have more time to prepare for the new standard, don’t procrastinate! Since leases are usually significant, it’s important to determine the impact to your balance sheet upon adoption of the new standard. Then you can communicate these anticipated changes to your financial statements users, including any lenders.
Jonathan Poppel, CPA