The FASB issued Accounting Standards Update No. 2016-02, Leases (ASC 842) in February of 2016. With the implementation timeline approaching, our clients are inquiring how this change will affect their valuations. Included below is a brief, high-level overview of the impact of the standard and issues to consider in valuation methodologies.
What are the major changes? Why was this made?
Russell Golden, the chairman of the FASB, indicated the new standard was in response to investors and other users of financial statements requesting a more transparent representation of companies’ lease obligations.
The most significant result from the new standard will be the treatment of operating leases. Prior to the new standard, operating leases were an off-balance sheet financed item with the obligations documented in the footnotes of the financial statements. ASC 842 requires operating leases to be booked on the balance sheet as a Right of Use Asset and Lease Liability.
What industries will be most impacted?
Intuitively, companies with large amounts of operating leases will be greatly impacted by the new accounting standard. Certain industries tend to lease many of their assets and will see a significant effect on their financial statements. Industries with a heavy real estate presence, such as retailers and wholesalers, will see balance sheet increases. For example, Walgreen’s has roughly $33 million of operating lease obligations that historically were not included on its balance sheet.The transportation industry could also realize a huge shift in assets and liabilities.
What is the timeline for implementation?
The new standard is effective for public companies on January 1, 2019 for accounting years beginning after December 15, 2018 and on January 1, 2020 for accounting years starting after December 15, 2019 for private entities. However, at its July 17, 2019 board meeting, the FASB tentatively decided to defer the effective date for non-public entities to January 1, 2021.
What is the high level accounting?
ASC 842 continues the dual categorization of leases: operating and financing.
- Under the new standard, both operating and financing leases will record a Right of Use (ROU) Asset and Lease Liability.
- Right of Use Asset = Amount of the Lease Liability + Initial Direct Costs + Payments made prior to commencement date LESS: Lease Incentives.
- Lease Liability = Present value of the minimum future lease payments, discounted at the stated lease rate or the company’s IBR (incremental borrowing rate).
Lease expense is recorded in the amount of the straight-line lease payment. A portion of this lease expense represents interest, but it is not itemized as such on the income statement.
The expense entries are interest expense and amortization of the Right of Use Asset.
What are the considerations for valuation?
We are fortunate to value many of our clients year after year. Unlike the change in tax rates due to the Tax Cuts and Jobs Act, which had a significant impact on valuation between years, a change in accounting rules does not affect the actual cash flows of a company. Therefore, conceptually, the new lease accounting rules should not impact value. The following are considerations in various valuation approaches.
For an operating lease, if the cash flows are being burdened with a lease expense, the value by discounting or capitalizing these cash flows is capturing the economic impact of the operating lease. The lease liability is by definition the present value of the future lease payments, which are being accounted for in calculating free cash flow. Therefore, deducting the liability would be double burdening the value for the lease obligations. As mentioned previously, a portion of this lease expense represents interest and might be deemed a financing cost, which needs to be excluded in calculating EBITDA.
The income statement presentation for financing leases includes interest expense and amortization, which are both added back to formulate free cash flows. Therefore, the impact of the lease obligations are not being captured in value and subtracting the lease liability is appropriate.
Future cash flows will need to be adjusted for the timing and duration of the lease obligations and associated lease expense.
When comparing the company being valued to the public guideline companies, several factors need to be considered.
- Timing difference for 2019 valuations – Public companies will have recorded operating leases on their balance sheets, while the subject company (private) may not as the requirement is not until 2020 (or 2021, if extended).
- Invested Capital for public companies will be higher because of the increased debt associated with the operating lease obligations. This will in turn affect indicated multiples.
- Lease terms should be considered. All other factors being equal, invested capital would be higher for companies with longer-term operating leases.
- Adequate detail of lease categorization for public companies may be difficult to obtain if source databases do not provide the break-out between capital and operating leases.
- The higher amount of debt of the public companies will affect leverage ratios, which can impact the WACC used in the valuation if it is based on the guideline companies’ capital structure.
- If the public companies have adopted IFRS 16 rather than ASC 842, there will be additional comparability issues because IFRS 16 does not differentiate between operating and financing leases. All lease obligations are accounted for as financing leases. Therefore, companies using IFRS will have higher EBITDAs compared to companies using ACS 842.