Basis of Presentation and Summary of Significant Accounting Policies
Basis of Presentation
As a result of the Business Combination, the Company is the acquirer for accounting purposes, and DTH is the acquiree and accounting predecessor. The Company’s financial statement presentation distinguishes a “Predecessor” for DTH for periods prior to the Closing Date. The Company is the “Successor” for periods after the Closing Date, which includes consolidation of DTH subsequent to the Business Combination on June 30, 2015. The Merger was accounted for as a business combination using the acquisition method of accounting, and the Successor financial statements reflect a new basis of accounting that is based on the fair value of the net assets acquired. See Note 3 for further discussion of the Business Combination. As a result of the application of the acquisition method of accounting as of the Closing Date, the financial statements for the Predecessor period and for the Successor period are presented on a different basis of accounting and are therefore, not comparable. The historical financial information of Del Taco, formerly LAC, prior to the Business Combination has not been reflected in the financial statements as those amounts have been considered de-minimus.
For the Consolidated Statements of Shareholders’ Equity, the Predecessor results reflect the equity balances and activities of DTH at December 30, 2014 through June 30, 2015 prior to the closing of the Business Combination and the Successor results reflect the LAC equity balances at June 30, 2015 prior to the closing of the Business Combination and the activities for Del Taco through January 2, 2018.
The Company’s fiscal year ends on the Tuesday closest to December 31. Fiscal years 2017 and 2015 are both a fifty-two week periods. In a fifty-two week fiscal year, the first, second and third quarters each include twelve weeks of operations and the fourth quarter includes sixteen weeks of operations. Fiscal year 2016 is a fifty-three week period. In a fifty-three week fiscal year, the first, second and third quarters each include twelve weeks of operations and the fourth quarter includes seventeen weeks of operations. For fiscal year 2017, the Company’s financial statements reflect the fifty-two weeks ended January 2, 2018 (Successor). For fiscal year 2016, the Company's financial statements reflect the fifty-three weeks ended January 3, 2017 (Successor). For fiscal year 2015, the Company’s financial statements reflect the twenty-six weeks ended December 29, 2015 (Successor) and the twenty-six weeks ended June 30, 2015 (Predecessor).
Principles of Consolidation
The consolidated financial statements included herein have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and the rules and regulations of Securities and Exchange Commission (“SEC”). The accompanying consolidated financial statements include the accounts of the Company and its wholly and majority owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of the consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Management believes that such estimates have been based on reasonable and supportable assumptions and the resulting estimates are reasonable for use in the preparation of the consolidated financial statements. Actual results could differ from these estimates. The Company’s significant estimates include estimates for impairment of goodwill, intangible assets and property and equipment, valuations provided in business combinations, insurance reserves, restaurant closure reserves, stock-based compensation, contingent liabilities, certain leasing activities and income tax valuation allowances.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Variable Interest Entities
In accordance with Accounting Standards Codification ("ASC") 810, Consolidation, the Company applies the guidance related to variable interest entities ("VIE"), which defines the process for how an enterprise determines which party consolidates a VIE as primarily a qualitative analysis. The enterprise that consolidates the VIE (the primary beneficiary) is defined as the enterprise with (1) the power to direct activities of the VIE that most significantly affect the VIE's economic performance and (2) the obligation to absorb losses of the VIE or the right to receive benefits from the VIE. The Company franchises its operations through franchise agreements entered into with franchisees and therefore, the Company does not possess any ownership interests in franchise entities or other affiliates. The franchise agreements are designed to provide the franchisee with key decision-making ability to enable it to oversee its operations and to have a significant impact on the success of the franchise, while the Company’s decision-making rights are related to protecting the Company’s brand. Additionally, the Company held a 1% ownership interest in four public limited partnerships in which the Company served as general partner. The limited partners had substantive kick-out rights over the general partner giving the limited partners power to direct the activities of the limited partnerships. The partnerships were liquidated and dissolved in December 2015. See the Related Party Transactions policy below for more information. Based upon the Company’s analysis of all the relevant facts and considerations of the franchise entities and the four public limited partnerships, the Company has concluded that the franchise agreements are not variable interest entities and the four public limited partnerships were not variable interest entities.
Company restaurant sales from the operation of company-operated restaurants are recognized when food and service is delivered to customers. Franchise revenue comprise (i) development fees, (ii) franchise fees, (iii) on-going royalties and (iv) renewal fees. Development and franchise fees, portions of which are collected in advance and are non-refundable, received pursuant to individual development agreements, grant the right to develop franchise-operated restaurants in future periods in specific geographic areas. Both development fees and franchise fees are deferred and recognized as revenue when the Company has substantially fulfilled its obligation pursuant to the development agreement. Development fees and franchise fees are generally recognized as revenue upon the opening of a franchise restaurant or upon termination of the development agreement with the franchisee. Deferred development fees and deferred franchise fees, which are included in other non-current liabilities on the consolidated balance sheets totaled $1.3 million and $1.4 million as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively. Royalties from franchise-operated restaurants are based on a percentage of franchise restaurant sales and are recognized in the period the related franchise-operated restaurant sales occur. Renewal fees are recognized when a renewal agreement becomes effective. The Company reports revenue net of sales taxes collected from customers and remitted to governmental taxing authorities. Promotional allowances totaled approximately $14.2 million during the fifty-two weeks ended January 2, 2018 (Successor), $13.6 million during the fifty-three weeks ended January 3, 2017 (Successor) and $5.8 million and $5.4 million during the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively. Franchise sublease income is comprised of rental income associated with properties leased or subleased to franchisees and is recognized as revenue on an accrual basis.
The Company sells gift cards to customers in its restaurants. The gift cards sold to customers have no stated expiration dates and are subject to potential escheatment laws in the various jurisdictions in which the Company operates. Deferred gift card income totaled $2.5 million and $2.4 million as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively. The current portion of the deferred gift card income is included in other accrued liabilities on the consolidated balance sheets and totaled $1.3 million and $1.2 million as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively. The non-current portion of the deferred gift card income was $1.2 million as of both January 2, 2018 (Successor) and January 3, 2017 (Successor) and is included in other non-current liabilities on the consolidated balance sheets. The Company recognizes revenue from gift cards: (i) when the gift card is redeemed by the customer; or (ii) under the delayed recognition method, when the likelihood of the gift card being redeemed by the customer is remote (gift card breakage) and the Company determines that there is not a legal obligation to remit the unredeemed gift cards to the relevant jurisdiction. The determination of the gift card breakage rate is based upon Company specific historical redemption patterns. Recognized gift card breakage revenue was not significant to any period presented in the consolidated statements of comprehensive income. Any future revisions to the estimated breakage rate may result in changes in the amount of breakage revenue recognized in future periods but is not expected to be significant.
Cash and Cash Equivalents
The Company considers short-term, highly liquid investments with original maturities of three months or less when purchased to be cash equivalents. Amounts receivable from credit card issuers are typically converted to cash within 2 to 4 days of the original sales transaction and are considered to be cash equivalents.
Accounts and Other Receivables, Net
Accounts and other receivables, net consist primarily of receivables from franchisees, sublease tenants, a vendor and landlords. Receivables from franchisees include sublease rents, royalties, services and contractual marketing fees associated with the franchise agreements. Sublease tenant receivables relate to subleased properties where the Company is a party and obligated on the primary lease agreement. The vendor receivable is for earned reimbursements from a vendor and the landlord receivables are for earned landlord reimbursement related to restaurants opened. The allowance for doubtful accounts is based on historical experience and a review on a specific identification basis of the collectability of existing receivables and totaled $0.1 million as of both January 2, 2018 (Successor) and January 3, 2017 (Successor).
The Company receives support from one of its vendors in the form of reimbursements. The reimbursements are agreed upon with the vendor, but do not represent specific, incremental, identifiable costs incurred by the Company in selling the vendor’s products. Such reimbursements are recorded as a reduction of the costs of purchasing the vendor’s products. The non-current portion of reimbursements received by the Company in advance is included in other non-current liabilities on the consolidated balance sheets and totaled $1.1 million and $1.6 million as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively. The current portion of these reimbursements is included in other accrued liabilities on the consolidated balance sheets and totaled $0.4 million as of both January 2, 2018 (Successor) and January 3, 2017 (Successor).
Inventories, consisting of food items, packaging and beverages, are valued at the lower of cost (first-in, first-out method) or market.
Property and Equipment
Property and equipment includes land, buildings, leasehold improvements, restaurant and other equipment, and buildings under capital leases. Land, leasehold improvements, property and equipment acquired in business combinations are initially recorded at their estimated fair value. Land, leasehold improvements, property and equipment acquired or constructed in the normal course of business are initially recorded at cost. The Company provides for depreciation and amortization based on the estimated useful lives of assets using the straight-line method.
Estimated useful lives for property and equipment are as follows:
Shorter of useful life (typically 20 years) or lease term
Buildings under capital leases
Shorter of useful life (typically 20 years) or lease term
Restaurant and other equipment
The estimated useful lives for leasehold improvements are based on the shorter of the estimated useful lives of the assets or the related lease term, which generally includes reasonably assured option periods expected to be exercised by the Company when the Company would suffer an economic penalty if not exercised. Depreciation and amortization expense associated with property and equipment totaled $21.0 million for the fifty-two weeks ended January 2, 2018 (Successor), $20.6 million for the fifty-three weeks ended January 3, 2017 (Successor) and $10.1 million and $7.1 million for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively. These amounts include $1.2 million for the fifty-two weeks ended January 2, 2018 (Successor), $1.4 million for the fifty-three weeks ended January 3, 2017 (Successor) and $0.8 million and $0.3 million for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively, related to buildings under capital leases. Accumulated depreciation and amortization associated with property and equipment includes $2.5 million and $2.2 million related to buildings under capital leases as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively.
The Company capitalizes construction costs which consist of internal payroll and payroll related costs and travel costs related to the successful acquisition, development, design and construction of the Company's new restaurants. Capitalized construction costs totaled $1.6 million for the fifty-two weeks ended January 2, 2018 (Successor), $1.3 million for the fifty-three weeks ended January 3, 2017 (Successor), respectively and $0.5 million for both the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor). If the Company subsequently makes a determination that a site for which development costs have been capitalized will not be acquired or developed, any previously capitalized development costs are expensed and included in general and administrative expenses in the consolidated statements of comprehensive income. The Company capitalizes interest in connection with the construction of its restaurants. Interest capitalized totaled approximately $0.1 million for both the fifty-two weeks ended January 2, 2018 (Successor) and the fifty-three weeks ended January 3, 2017 (Successor) and $25,000 and $40,000 for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively.
Gains and losses on the disposal of assets are recorded as the difference between the net proceeds received and net carrying values of the assets disposed and are included in loss on disposal of assets, net in the consolidated statements of comprehensive income.
Deferred Financing Costs
Deferred financing costs represent third-party debt costs that are capitalized and amortized to interest expense over the associated term using the effective interest method. Deferred financing costs, along with lender debt discount, are presented net of the related debt balances on the consolidated balance sheets.
Goodwill and Trademarks
The Company’s goodwill and trademarks are not amortized, but tested annually for impairment and tested more frequently for impairment if events and circumstances indicate that the asset might be impaired. The Company conducts annual goodwill and trademark impairment tests in the fourth quarter of each fiscal year or whenever an indicator of impairment exists.
In assessing potential goodwill impairment, the Company has the option to first assess the qualitative factors to determine whether events or circumstances indicate that it is more likely than not that the fair value of net assets, including goodwill, is less than its carrying amount. If the qualitative factors indicate that it is more likely than not that the fair value of net assets, including goodwill, is less than its carrying amount, the Company performs a two-step impairment test of goodwill. In the first step, the Company estimates the fair value of net assets, including goodwill, and compares it to the carrying value of net assets, including goodwill. If the carrying value exceeds the estimated fair value of net assets, including goodwill, the second step is performed to measure the amount of the impairment loss, if any. In the second step, the amount of the impairment loss is the excess of the carrying amount of the goodwill over its implied fair value.
The methods the Company uses to estimate fair value include discounted future cash flows analysis and market valuation based on similar companies. Key assumptions included in the cash flow model include future revenues, operating costs, working capital changes, capital expenditures and a discount rate that approximates the Company's weighted average cost of capital.
In assessing potential impairments for the fourth quarter test for 2017, the Company performed a qualitative assessment to determine whether it is more likely than not that the fair value of goodwill or indefinite-lived trademark are less than the carrying amount. Upon completion of the fourth quarter 2017 annual impairment assessment, the Company determined that no goodwill or trademark impairment was indicated. As of January 2, 2018, the Company is not aware of any significant indicators of impairment that exist for goodwill or trademark that would require additional analysis.
Intangible Assets, Net
Intangible assets primarily include favorable lease assets and franchise rights. Favorable lease assets represent the fair values of acquired lease contracts having contractual rents that are favorable compared to fair market rents as of the Closing Date of the Business Combination, and are amortized on a straight-line basis over the remaining lease term to expense in the consolidated statements of comprehensive income. Franchise rights, which represent the fair value of franchise agreements based on the projected royalty revenue stream as of the Closing Date of the Business Combination, are amortized on a straight-line basis to depreciation and amortization expense in the consolidated statements of comprehensive income over the remaining term of the franchise agreements.
Other Assets, Net
Other assets, net consist of security deposits and other capitalized costs. The Company capitalizes certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use when both the preliminary project stage is completed and it is probable that the software will be used as intended. Capitalized software costs include only (i) external direct costs of materials and services utilized in developing or obtaining computer software, and (ii) compensation and related benefits for employees who are directly associated with the software projects. Capitalized software costs are amortized over the estimated useful life, typically 3 years. The net carrying value of capitalized software costs for the Company totaled $2.1 million and $2.0 million as of January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively, and is included in other assets, net in the consolidated balance sheets. Capitalized software costs totaled $1.0 million for the fifty-two weeks ended January 2, 2018 (Successor), $1.3 million for the fifty-three weeks ended January 3, 2017 (Successor) and $0.6 million and $0.5 million for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively. Amortization expenses totaled $1.0 million for the fifty-two weeks ended January 2, 2018 (Successor), $0.9 million for the fifty-three weeks ended January 3, 2017 (Successor) and $0.4 million for both the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor).
Long-lived assets, including property and equipment and definite lived intangible assets (other than goodwill and indefinite-lived intangible assets), are reviewed by the Company for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Long-lived assets are grouped and evaluated for impairment at the lowest level for which there are identifiable cash flows that are independent of the cash flows of other groups of assets. The Company evaluates such cash flows for individual restaurants and franchise agreements on an undiscounted basis. If it is determined that the carrying amounts of such long-lived assets are not recoverable, the assets are written down to their estimated fair values. The Company generally estimates fair value using either the land and building real estate value for the respective restaurant or the discounted value of the estimated cash flows associated with the respective restaurant or agreement.
Rent Expense and Deferred Rent Liability
The Company has non-cancelable lease agreements for certain restaurant land and buildings under terms ranging up to 35 years, with one to four options to extend the lease generally for five to ten years per option period. At inception, each lease is evaluated to determine whether it will be classified as an operating or capital lease. Certain leases provide for contingent rentals based on percentages of net sales or have other provisions obligating the Company to pay related property taxes and certain other expenses. Contingent rentals are generally based on sales levels in excess of stipulated amounts as defined in the lease agreement, and thus are not considered minimum lease payments and are included in rent expense as incurred. Certain leases contain fixed and determinable escalation clauses for which the Company recognizes rental expense under these leases on the straight-line basis over the lease terms, which includes the period of time from when the Company takes possession of the leased space until the restaurant opening date (the rent holiday period), and the cumulative expense recognized on the straight-line basis in excess of the cumulative payments is included in other non-current liabilities. In addition, the Company subleases certain buildings to franchisees and other unrelated third parties, which are classified as operating leases.
In some cases, the land and building the Company will lease requires construction to ready the space for its intended use, and in certain cases, the Company has involvement with the construction of leased assets. The construction period begins when the Company executes the lease agreement with the landlord and continues until the space is substantially complete and ready for its intended use. In accordance with ASC 840, Leases, the Company must consider the nature and extent of its involvement during the construction period.
The Company may expend cash for structural additions on leased premises that may be reimbursed in whole or in part by landlords as construction contributions pursuant to agreed-upon terms in the leases. Depending on the specifics of the leased space and the lease agreement, the amounts paid for structural components will be recorded during the construction period as construction-in-progress and the landlord construction contributions will be recorded as a deferred rent liability. Upon completion of construction for those leases that meet certain criteria, the lease may qualify for sale-leaseback treatment. For these leases, the deferred rent liability and the associated construction-in-progress will be removed and any gain on sale will be recorded as deferred income and amortized over the lease term to gain on disposal of assets and any loss on sale will be expensed immediately to loss on disposal of assets, net. If the lease does not qualify for sale-leaseback treatment, the deferred rent liability will be reclassified to a deemed landlord financing liability and will be amortized over the lease term based on the rent payments designated in the lease agreement with rent payments applied to deemed landlord financing liability and interest expense.
Unfavorable lease liabilities represent the fair value of acquired lease contracts having contractual rents that are unfavorable compared to fair market rents and are amortized on a straight-line basis over the expected lease term to expense in the consolidated statements of comprehensive income. As of January 2, 2018 (Successor) and January 3, 2017 (Successor), unfavorable lease liabilities had a gross carrying value of $20.6 million and $21.0 million with accumulated amortization of $6.1 million and $3.9 million, respectively. The Company reclassified $2.6 million of unfavorable lease liabilities during the fourth quarter of fiscal 2015 related to the 12 closed underperforming locations and re-characterized the amount as restaurant closure liability, as described in Note 4. Amortization credits recorded for unfavorable lease liabilities were $2.7 million during the fifty-two weeks ended January 2, 2018 (Successor), $2.6 million during the fifty-three weeks ended January 3, 2017 (Successor) and $1.3 million and $0.3 million during the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively. The weighted-average amortization period as of January 2, 2018 (Successor) for unfavorable lease liabilities equaled 7.9 years. The estimated future amortization for unfavorable lease liabilities for the next five fiscal years is as follows (in thousands):
Unfavorable Lease Liabilities
Given the nature of the Company’s operating environment, the Company is subject to workers’ compensation and general liability claims. To mitigate a portion of these risks, the Company maintains insurance for individual claims in excess of deductibles per claim (the Company’s insurance deductibles range from $0.25 million to $0.50 million per occurrence for workers’ compensation and are $0.35 million per occurrence for general liability). The Company is not the primary obligor for its worker's compensation insurance policy. The amount of loss reserves and loss adjustment expenses is determined based on an estimation process that uses information obtained from both Company-specific and industry data, as well as general economic information. Loss reserves are based on estimates of expected losses for determining reported claims and as the basis for estimating claims incurred but not reported. The estimation process for loss exposure requires management to continuously monitor and evaluate the life cycle of claims. Management also monitors the reasonableness of the judgments made in the prior year’s estimation process (referred to as a hindsight analysis) and adjusts current year assumptions based on the hindsight analysis. The Company utilizes actuarial methods to evaluate open claims and estimate the ongoing development exposure related to workers’ compensation and general liability.
Franchisees pay a monthly fee to the Company of 4% of their restaurants’ net sales as reimbursement for advertising and promotional services that the Company provides. Fees received in advance of payment for provided services are included in other accrued liabilities and were $0.3 million and $0.7 million at January 2, 2018 (Successor) and January 3, 2017 (Successor), respectively. Company-operated restaurants contribute to the advertising fund on the same basis as franchise-operated restaurants. At January 2, 2018 (Successor) and January 3, 2017 (Successor), the Company had an additional $0.4 million and $1.0 million, respectively, accrued for this requirement.
Production costs for radio and television advertising are expensed when the commercials are initially aired. Costs of distribution of advertising are charged to expense on the date the advertising is aired or distributed. These costs, as well as other marketing-related expenses for advertising are included in occupancy and other operating expenses in the consolidated statements of comprehensive income. Advertising expenses for the Company were $18.1 million for the fifty-two weeks ended January 2, 2018 (Successor), $17.2 million for the fifty-three weeks ended January 3, 2017 (Successor) and $7.6 million and $8.7 million for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively.
Pre-opening costs, which include restaurant labor, supplies, cash and non-cash rent expense and other costs incurred prior to the opening of a new restaurant are expensed as incurred. Pre-opening costs were $1.6 million for the fifty-two weeks ended January 2, 2018 (Successor), $0.7 million for the fifty-three weeks ended January 3, 2017 (Successor) and $0.4 million and $0.3 million for the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor), respectively.
Restaurant Closure Charges, Net
The Company makes decisions to close restaurants based on their cash flows, anticipated future profitability and leasing arrangements. The Company determines if discontinued operations treatment is appropriate and estimates the future obligations, if any, associated with the closure of restaurants and records the corresponding restaurant closure liability at the time the restaurant is closed. These restaurant closure obligations primarily consist of the liability for the present value of future lease obligations, net of estimated sublease income. Restaurant closure charges, net are comprised of direct costs related to the restaurant closure and initial charges associated with the recording of the liability at fair value, accretion of the restaurant closure liability during the period, any positive or negative adjustments to the restaurant closure liability in subsequent periods as more information becomes available and sublease income from leases which are treated as deemed landlord financing. Changes to the estimated liability for future lease obligations based on new facts and circumstances are considered to be a change in estimate and are recorded prospectively. Accretion expense is recorded in order to appropriately reflect the present value of the lease obligations as of the end of a reporting period. Lease payments net of sublease income received related to these obligations reduce the overall liability. To the extent that the disposal or abandonment of related property and equipment results in gains or losses, such gains or losses are included in loss on disposal of assets, net in the consolidated statements of comprehensive income, except for gains or losses on the disposal of property and equipment related to the 12 underperforming restaurants, which are included in restaurant closure charges, net on the consolidated statements of comprehensive income.
Stock-Based Compensation Expense
The Company measures and recognizes compensation expense for all share-based payment awards made to employees based on their estimated grant date fair values using the Black-Scholes option pricing model for option grants and the closing price of the underlying common stock on the date of the grant for restricted stock awards. Stock-based compensation expense for the Company’s stock-based compensation awards is recognized ratably over the vesting period on a straight-line basis.
The Company uses the liability method of accounting for income taxes. Deferred income taxes are provided for temporary differences between financial statement and income tax reporting, using tax rates scheduled to be in effect at the time the items giving rise to the deferred taxes reverse. The Company recognizes the impact of a tax position in the financial statements if that position is more likely than not of being sustained by the taxing authority. Accordingly, the Company reports a liability for unrecognized tax benefits resulting from uncertain tax positions taken or expected to be taken in a tax return. The Company recognizes interest and penalties, if any, related to unrecognized tax benefits in income tax expense.
Derivative Instruments and Hedging Activities
The Company is exposed to variability in future cash flows resulting from fluctuations in interest rates related to its variable rate debt. As part of its overall strategy to manage the level of exposure to the risk of fluctuations in interest rates, the Company has used various interest rate contracts including interest rate caps. The Company recognizes all derivative instruments as either assets or liabilities at fair value in the consolidated balance sheets. When they qualify as hedging instruments, the Company designates interest rate caps as cash flow hedges of forecasted variable rate interest payments on certain debt principal balances.
For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Gains and losses on the derivative representing hedge ineffectiveness are recognized in current earnings.
The Company enters into interest rate derivative contracts with major banks and is exposed to losses in the event of nonperformance by these banks. The Company anticipates, however, that these banks will be able to fully satisfy their obligations under the contracts. Accordingly, the Company does not obtain collateral or other security to support the contracts.
The Company recognizes liabilities for contingencies when an exposure that indicates it is probable that an asset has been impaired or that a liability has been incurred and the amount of impairment or loss can be reasonably estimated. The Company’s ultimate legal and financial liability with respect to such matters cannot be estimated with certainty and requires the use of estimates. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. The Company records legal settlement costs when those costs are probable and reasonably estimable.
Comprehensive Income (Loss)
Comprehensive income (loss) includes changes in equity from transactions and other events and circumstances from nonoperational sources, including, among other things, the Company’s unrealized gains and losses on effective interest rate caps which are included in other comprehensive income (loss), net of tax.
An operating segment is defined as a component of an enterprise that engages in business activities from which it may earn revenues and incur expenses, and about which separate financial information is regularly evaluated by the Company’s chief operating decision makers in deciding how to allocate resources. Similar operating segments can be aggregated into a single operating segment if the businesses are similar. Management has determined that the Company has one operating segment, and therefore one reportable segment. The Company’s chief operating decision maker (CODM) is its Chief Executive Officer; its CODM reviews financial performance and allocates resources at a consolidated level on a recurring basis.
Related Party Transactions
Of the 424,439 warrants purchased during the fifty-two weeks ended January 2, 2018 (Successor), 400,000 warrants were purchased from PW Acquisitions, LP, a related party, at $3.75 per warrant, representing a 5% discount from the closing price of $3.95 per warrant on the transaction date. A member of the Company's Board of Directors is the chief executive officer and managing member of the general partner of PW Acquisitions, LP.
The Company previously entered into long-term leases for 22 Del Taco restaurants whereby the lessors were one of four public partnerships where the Company served as general partner with a 1% ownership interest. The leases required monthly rent payments in an amount equal to 12% of gross sales which were recorded within occupancy and other operating expenses in the consolidated statements of comprehensive income and totaled $1.4 million for both the twenty-six weeks ended December 29, 2015 (Successor) and June 30, 2015 (Predecessor).
The Company recorded a fair value adjustment through the initial purchase price allocation, as described in Note 3, of $1.5 million for the estimated fair value of its investment in the four public partnerships.
On July 24, 2015, the four public partnerships entered into an agreement to sell all of the properties, subject to the approval by a majority in interest of the limited partners in each of the public partnerships, to a third party that is not affiliated with the Company. The sale of the properties included new long-term leases between the Company and the third party buyer and was approved by the respective limited partners on November 23, 2015. On December 14, 2015, the four public partnerships consummated the sale, and were subsequently liquidated and dissolved and the assets of the respective partnerships were distributed pursuant to the terms of their respective partnership agreements. During the twenty-six weeks ended December 29, 2015 (Successor), the Company recorded a gain of $0.2 million, included in other income in the consolidated statements of comprehensive income, based on the approximate $1.8 million distribution received in excess of the $1.6 million carrying value of its investment in the partnerships.
At December 30, 2014 (Predecessor), DTH had $108.1 million of subordinated notes outstanding due to its three largest shareholders that bore interest at 13.0%. On March 20, 2015, DTH used proceeds from the Step 1 of the Business Combination, as described in Note 3, a $10.0 million revolver borrowing and amended term loan proceeds of $25.1 million to fully redeem the then outstanding balance of $111.2 million of subordinated notes. Interest expense related to subordinated notes was $3.1 million for the twenty-six weeks ended June 30, 2015 (Predecessor). See Note 8 for further discussion regarding the subordinated notes.
Fair Value of Financial Instruments
The Company measures fair value using the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The Company uses valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on the underlying inputs, each fair value measurement in its entirety is reported in one of the three tiers in the fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:
Level 1, defined as observable inputs such as quoted prices in active markets;
Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and
Level 3, defined as unobservable inputs which reflect the Company’s own estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques may include the use of third-party pricing services, option pricing models, discounted cash flow models and similar techniques.
Concentration of Risks
Financial instruments that potentially subject the Company to a concentration of credit risk are cash and cash equivalents. The Company maintains its day-to-day operating cash balances in non-interest-bearing accounts. Although the Company at times maintains balances that exceed amounts insured by the Federal Deposit Insurance Corporation, it has not experienced any losses related to these balances and management believes the credit risk to be minimal.
The Company extends credit to franchisees for franchise and advertising fees on customary credit terms, which generally do not require collateral or other security. In addition, management believes there is no concentration of risk with any single franchisee or small group of franchisees whose failure or nonperformance would materially affect the Company’s results of operations.
The Company has entered into a long-term purchase agreement with a distributor for delivery of essentially all food and paper supplies to all company-operated and franchise-operated restaurants except for one location in Guam. Disruption in shipments from this distributor could have a material adverse effect on the results of operations and financial condition of the Company. However, management of the Company believes sufficient alternative distributors exist in the marketplace although it may take some time to enter into replacement distribution arrangements and the cost of distribution may increase as a result.
As of January 2, 2018, Del Taco operated and franchised a total of 373 restaurants in California (252 company-owned and 121 franchise-operated locations). As a result, the Company is particularly susceptible to adverse trends and economic conditions in California. In addition, given this geographic concentration, negative publicity regarding any of the restaurants in California could have a material adverse effect on the Company’s business and operations, as could other regional occurrences such as local strikes, fires, earthquakes or other natural disasters.
Recently Adopted Accounting Standards
In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2017-01, Business Combinations (Topic 804): Clarifying the Definition of a Business. This ASU clarifies the definition of a business with the objective of adding guidance to assist entities with evaluating whether certain transactions should be accounted for as acquisitions or disposals of assets or businesses. The Company elected, as permitted by the standard, to early adopt ASU 2017-01 in the third quarter of 2017. The adoption of ASU 2017-01 did not have a material impact to the Company's consolidated financial statements.
In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, which is intended to simplify various aspects of accounting for share-based compensation arrangements, including the income tax impact, classification on the statement of cash flows and forfeitures. This standard is effective for annual reporting periods beginning after December 15, 2016, and interim periods within that reporting period, with early adoption permitted. As ASU 2016-09 requires recognition of certain tax benefits associated with stock-based compensation on a discrete basis, the Company anticipates that its effective tax rate may vary from quarter to quarter depending on the Company’s stock price in each period. The Company anticipates that ASU 2016-09 will potentially increase or lower its effective tax rate, relative to the U.S. statutory rate, depending on the amount of stock-based compensation deductible for tax related to the vesting of restricted stock awards or exercise of stock options as compared to cumulative stock-based compensation recorded. The Company adopted ASU 2016-09 during the first fiscal quarter of 2017. The Company will continue to estimate forfeitures.
Recently Issued Accounting Standards
In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which amends and simplifies existing guidance in order to allow companies to more accurately present the economic effects of risk management activities in the financial statements. The standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those years. Early adoption is permitted. The Company is currently evaluating the impact of the standard on its consolidated financial statements and related disclosures.
In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The standard simplifies the subsequent measurement of goodwill, requiring only a single-step quantitative test to identify and measure impairment based on the excess of a reporting unit's carrying amount over its fair value. A qualitative assessment may still be completed first for an entity to determine if a quantitative impairment test is necessary. This standard is effective for fiscal years beginning after December 15, 2019, with early adoption permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. The standard requires adoption on a prospective basis. The adoption of this standard is not expected to have a material impact on the Company's consolidated financial statements.
In March 2016, the FASB issued ASU No. 2016-04, Liabilities-Extinguishment of Liabilities (Subtopic 405-20): Recognition of Breakage for Certain Prepaid Stored-Value Products, which is designed to provide guidance and eliminate diversity in the accounting for the derecognition of financial liabilities related to certain prepaid stored-value products using a revenue-like breakage model. This standard is effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years, with early adoption permitted. This standard is to be applied retrospectively or using a cumulative effect transition method as of the date of adoption. The Company is currently evaluating the impact of the standard on its consolidated financial statements and related disclosures as well as the expected adoption method.
In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). This guidance will result in key changes to lease accounting and will aim to bring leases onto balance sheets to give investors, lenders, and other financial statement users a more comprehensive view of a company's long-term financial obligations as well as the assets it owns versus leases. The new leasing standard will be effective for fiscal years beginning after December 15, 2018, and for interim periods within those fiscal years. The new guidance requires a modified retrospective transition approach for all leases existing at, or entered into after, the date of initial application, with certain practical expedients available. Based on a preliminary assessment, the Company expects that substantially all of its operating lease commitments will be subject to the new guidance and recognized as operating lease liabilities and right-of-use assets upon adoption, resulting in a material increase in the assets and liabilities on the Company's consolidated balance sheets. The Company is continuing its evaluation, which may identify additional impacts this standard will have on its consolidated financial statements and related disclosures. The Company will adopt ASU 2016-02 during the first quarter of fiscal 2019.
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which provides a comprehensive new revenue recognition model that requires a company to recognize revenue in an amount that reflects the consideration it expects to receive for the transfer of promised goods or services to its customers. The standard also requires additional disclosure regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. This ASU is effective for annual periods and interim periods beginning after December 15, 2017. ASU 2014-09 is to be applied retrospectively or using a cumulative effect transition method. The Company will adopt ASU 2014-09 in fiscal year 2018, using the modified retrospective method of adoption.
ASU 2014-09 will not materially impact the recognition of company restaurant sales or franchise royalty income from franchisees included in franchise revenue. Franchise sublease income is not within the scope of this new guidance.
The adoption of ASU 2014-09 will change the timing of the recognition of initial franchise fees, including franchise and development fees, and renewal fees, both included in franchise revenue in the consolidated statements of comprehensive income. Currently, initial franchise fees are recognized when all material obligations have been performed and conditions have been satisfied, typically when operations of a new franchise restaurant have commenced, and renewal fees are recognized when a renewal agreement becomes effective. ASU 2014-09 requires franchise and renewal fees to be deferred and recognized over the term of the related franchise agreement for the respective restaurant. The impact of the deferral of initial franchise and renewal fees received in a given year may be offset by the recognition of revenue from fees retrospectively deferred from prior years. Upon adoption, the Company will record approximately $1.0 million as a cumulative effect adjustment to opening retained earnings and deferred revenue as of January 3, 2018 (the first day of fiscal 2018) related to franchise and renewal fees previously recognized since the Business Combination on June 30, 2015. During fiscal 2017 and 2016, the Company recorded initial franchise and renewal fees of $0.6 million and $0.3 million, respectively, as component of franchise revenue in the consolidated statements of comprehensive income.
The adoption of the new guidance will change the reporting of advertising fund contributions from franchisees and the related advertising fund expenditures, which are not currently included in the consolidated statements of comprehensive income. ASU 2014-09 requires these advertising fund contributions and expenditures to be reported on a gross basis in the consolidated statements of comprehensive income, which will have an impact to our total revenues and expenses. However, the Company expects such advertising fund contributions and expenditures will be largely offsetting and therefore does not expect a significant impact on its reported net income. Franchise contributions to the Company's advertising programs for fiscal 2017 and 2016 were $12.7 million and $12.1 million, respectively.
Additionally, certain other franchise expenses have been recorded net of the related fees received from franchisees. Under ASU 2014-09, the Company will include these revenues and expenditures on a gross basis within the consolidated statements of comprehensive income. While this change will materially impact the gross amount of reported franchise revenue and related expenses on the consolidated statements of comprehensive income, the impact will be an offsetting increase to both revenue and expense such that there will not be a significant, if any, impact on operating income and net income. Other franchise fees received from franchisees for fiscal 2017 and 2016 were $0.8 million and $0.8 million, respectively.