By Terrel J. Lavergne (“Murph”), CPA/ABV, CVA
In February 2016, new lease accounting requirements were issued that would require lessees to recognize an asset and a lease liability on its balance sheet for most leases, including operating leases.
This requirement replaces the previous GAAP leasing standard ASC 840 with ASC 842. Unlike ASC 840, which allowed operating leases to be reported in the footnotes of financial statements, under ASC 842, other than leases with terms of 12 months or less, leases are required to be capitalized.
Under ASC 842, operating leases must be recognized on the balance sheet by recording a lease liability and a right-of-use-asset. The lease liability is determined by using an appropriate discount rate to calculate the present value of future lease payments. In choosing an appropriate discount rate, lessees are required to use the rate implicit in the lease if readily determinable. If unable to determine the implicit rate, the lessee is to use its incremental borrowing rate. Private companies may elect to use a so-called risk-free rate.
The new standard still requires just one lease/rental expense to be reported on the income statement. Finance leases and assets purchased with debt record amortization and/or interest expense. For operating leases, the combination of the amortization of the right-of-use-asset and the interest growth of the liability is recorded as a lease expense.
The standard is expected to have a material impact on most companies’ balance sheets. According to Deloitte, the new standard is estimated to bring $2 trillion of lease liability into S&P 500 balance sheets. Because of the potentially significant impact on balance sheets, violations of debt covenants could result.
For public companies, the change is effective after December 15, 2018 for fiscal years and interim periods within those fiscal years. The FASB proposal to delay the effective date of private company and not-for-profit compliance was approved, making the new effective date January 1, 2021. The delay seeks to give private companies extra time to learn from the experiences of public companies. It is expected that early adoption will be permitted for all entities.
Because of changes in balance sheet reporting, some financial statement ratios may be affected. Enterprise value (or total invested capital) includes common and preferred equity and interest-bearing debt. Equity values should not change but, when operating lease liabilities are considered, enterprise values of companies will be expanded to include additional debt. Because of a higher invested capital, returns on invested capital ratio generally will be lower. This would also affect the EV/EBITDA multiples.
The change in lease accounting could have implications for determination of the purchase price in M&A transactions. When valuing private companies, we often refer to valuation multiples of similar public companies. Considering the new standard, the analyst needs to determine the effect on public company multiples and the need to make any restatements.
In summary, in valuations, operating leases should be treated as what they are, debt. Because some companies will defer the adoption of the new standard, there will be a lack of comparability of valuation metrics involving assets and liabilities across businesses. If operating leases are not capitalized, enterprise values and debt levels are not comparable. Another possible valuation implication is that some companies will not break down operating lease payments between interest and depreciation or amortization.
The new standard will have a significant impact on the key metrics the companies report to their investors and banking institutions, as examples below show:
- Debt to equity ratio increases (debt added with no change to equity), raising a company’s leverage.
- Debt service coverage – debt is added without a change to EBITDA (earnings before interest, taxes, depreciation, and amortization).
- Ratio of current assets/current liabilities decreases.
- Working capital (current assets minus current liabilities) decreases.
- Return on assets (net income divided by assets) decreases.
If you have any questions about the effect that these changes might have on your company’s valuation, please contact: Greg, Matt, Alex
 https://www2.deloitte.com/us/en/pages/audit/articles/a-roadmap-to-applying-the-new-leasing-standard.html. Accessed January 10, 2020.
https://www.redw.com/blog/2019/05/09/how-the-new-lease-accounting-standard-will-affect-businesses/. Accessed January 10, 2020.