The Financial Accounting Standards Board

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1 V A L U A T I O N How the New Leases Standard May Impact Business Valuations By Judith H. O Dell, CPA, CVA The Financial Accounting Standards Board issued the 485 page Leases Standard (Topic 842) in February, 2016 after almost seven years of deliberations. It will affect any entity that enters into a lease (both lessors and lessees) and that prepares financial statements using U.S. GAAP or IFRS. Although it is not effective for public companies until fiscal years beginning after December 15, 2018 and for private companies a year later, many companies are already preparing for implementation. It is worth looking ahead to consider how the new standard might impact metrics and multiples used in business valuations. This article will focus on the lessee, although the standard seeks to align some aspects of lessor accounting with that of lessees. NEW ACCOUNTING FOR LEASES Many companies have entered into leases structured to allow them to be accounted for as operating leases under current GAAP and thus off balance sheet. Users of financial statements have told the Board that they typically adjust a lessee s financial statements to capitalize leases, but lacking detailed information about the leases, these adjustments were estimates. Likewise, valuation analysts will make adjustments when lease obligations are material but may have more complete information to make the adjustments. The new standard will require lessees to recognize assets and liabilities that arise from leases. For leases with a term of twelve months or less there is an accounting policy election that allows a company not to recognize the lease assets and liabilities and to expense the lease payments. For all other leases, the lessee will recognize in the statement of financial position a liability to make lease payments and a right-of-use asset representing the right to use the underlying asset. There continues to be a differentiation between finance leases and operating leases in U.S. GAAP. IFRS 16 requires all leases to be accounted for as finance leases. The following is a very brief overview of the standard. The standard defines what is a lease and what is not a lease, contains a glossary of terms used, provides detailed accounting and disclosure guidance and examples, as well as transition guidance including practical expedients. FINANCE LEASES VS. OPERATING LEASES The accounting for finance leases is similar to existing GAAP for capital leases; however, the criteria have changed from the former bright lines that separated a capital (now finance) lease from an operating lease. A lease is classified as a finance lease if it meets any of the following criteria at lease inception: 1 It transfers ownership of the underlying asset to the lessee by the end of the lease term. The lease grants the lessee an option to purchase the 1 FASB Accounting Standards Codification

2 underlying asset that the lessee is reasonably certain to exercise. The lease term is for the major part of the remaining economic life of the underlying asset. The present value of the sum of the lease payments and any residual value guaranteed by the lessee equals or exceeds substantially all of the fair value of the underlying asset. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. If none of the criteria are met, a lessee shall classify the lease as an operating lease. From a practical standpoint, leases of office and retail space will most likely meet the criteria of an operating lease while leases of equipment and vehicles will most likely meet the criteria of a finance lease. Many private companies lease real estate and/or equipment from related parties and in many cases there are no formal leases. The standard states that leases between related parties should be classified in accordance with the lease classification applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. 2 The Basis for Conclusions (BC374) recognizes that some leases are not documented, and/or terms and conditions are not at arm s length. Valuation analysts usually normalize income statements to include a fair market basis rent. The balance sheet may need to be normalized to include a right-of-use asset and related liability once the standard is effective. INITIAL MEASUREMENT At the commencement date, a lessee shall measure both of the following: 3 The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease. The discount rate is based on information available at the commencement date and can be the rate implicit in the lease. If this rate is not readily determinable, then the lessee uses its incremental borrowing rate. There is a special provision for private companies that do not have an incremental borrowing rate to use a risk free discount rate as an accounting policy election. However, use of the 2 Ibid. Section Ibid through 3. lower risk free rate will most likely result in greater rightof-use asset and lease liability. The right-of-use asset which shall consist of the amount of the initial measurement of the lease liability, plus any lease payments made to the lessor before the commencement of the lease minus any lease incentives received plus any initial direct costs incurred by the lessee. 4 SUBSEQUENT MEASUREMENT The lease liability is measured by increasing the carrying amount to reflect interest on the lease liability and reducing the carrying amount to reflect the lease payments made during the period. The lessee shall determine the interest on the lease liability in each period during the lease term as the amount that produces a periodic discount rate on the remaining balance of the liability, taking into account reassessment requirements. 5 For an operating lease, a single lease cost is recognized, calculated so the cost of the lease is allocated over the lease term on generally straight line basis. The expense is included in the lessee s income from continuing operations. 6 The right-of-use asset for a finance lease is amortized on a straight line basis (unless another systematic basis is more representative of the pattern of use) from the commencement date to the earlier of the end of the life of the right-to-use asset or the end of the lease term. 7 Unlike an operating lease, the interest expense on the lease liability and amortization of the right of use asset are presented in a manner consistent with how the entity presents other interest expense and depreciation or amortization of similar assets, respectively. 8 FINANCE LEASE EXAMPLE A lessee enters into a ten-year lease of a piece of equipment. There are no initial direct costs, variable payments or other increases. The total rent is $600,000. The annual rent is $60,000 per year payable at $5,000 per month. The rate implicit in the lease is not readily determinable. The lessee s incremental borrowing rate is six percent. The present value of the $5,000 monthly lease payment is $450,367 as shown 4 Ibid Ibid Ibid Ibid and 8. 8 Ibid

3 on Table 1. The lessee measures the right of use asset at $450,367 and the same amount for the liability. According to the amortization schedule, the lessee determines that at the end of the first year the interest expense is $26,100. TABLE 1: LEASE AMORTIZATION SCHEDULE Year Beginning Ending Interest Payment Balance Balance Principal 1 $450,367 $26,100 $60,000 $416,467 $33,900 2 $416,467 $24,009 $60,000 $380,476 $35,991 3 $380,476 $21,789 $60,000 $342,265 $38,211 4 $342,265 $19,432 $60,000 $301,698 $40,567 5 $301,698 $16,930 $60,000 $258,628 $43,070 6 $258,628 $14,274 $60,000 $212,902 $45,726 7 $212,902 $11,453 $60,000 $164,355 $48,547 8 $164,355 $8,459 $60,000 $112,814 $51,541 9 $112,814 $5,280 $60,000 $58,095 $54, $58,095 $1,905 $60,000 $0 $58,095 The entity would make the following entries: (Table 2) TABLE 2: JOURNAL ENTRIES Finance Lease Debit Credit 1/1/xxxx Right-of-use asset 450,367 Lease payable 450,367 End of first year (there would be monthly entries) Lease payable 60,000 Year-end balances Cash 60,000 Amortization 45,036 Right-of-use asset 45,036 Interest expense 26,100 Lease payable 26,100 Right-of-use asset 405,331 Lease payable 416,467 Interest expense 26,100 Amortization 45,036 At the end of the first year, the lessee records amortization expense of $45,036 ($450,367/10) and the right-of-use asset balance is $405,331 ($450,367 less $45,036). 8

4 At the end of the first year, the lessee adds $26,100 of interest to the liability balance and subtracts the $60,000 payments made, leaving a balance of $416,467. Note that while the annual lease payment is $60,000, the total expense recognized for interest and amortization is $71,136; this amount will decrease each year though the life of the lease. The results are somewhat similar to depreciation and interest expense as if the asset had been purchased and financed. OPERATING LEASE EXAMPLE Assume the same facts as above except that the lease is for office space and meets the criteria for an operating lease. In this case, the annual rent expense is $60,000. It would be included within income from continuing operations, most likely classified as rent expense. The entity would make the following entries, shown on Table 3. TABLE 3: OPERATING LEASE EXAMPLE* Operating Lease Debit Credit 1/1/xxxx Right-of-use asset 450,367 Lease payable 450,367 End of first year (would be monthly entries) Year-end balance Rent expense 60,000 Cash 60,000 Right-of-use asset 33,900 Lease payable 33,900 Right-of-use asset 416,467 Lease payable 416,467 Rent expense 60,000 *MVIC adjusted by BB&D to compensate for seller-financing and difference between firm profit/loss reporting date vs. Transaction date. The right-of-use asset is calculated at the original amount of $450,367 less the rent of $60,000 plus interest expense of $26,100 for a total of $416,467. Interest expense of $26,100 is added to the initial lease liability of $450,367 and the rent payment are deducted so that the liability of $416,467 equals the right-of-use asset. The year-end balance of the liability is the same for both finance and operating leases in this example, but the right-of-use asset is not. Note that in this simple operating lease example, rent expense is constant throughout the life of the lease and does not take into account any scheduled increases or variable payments. The standard describes, in detail, how these are to be accounted for. EFFECTS ON BUSINESS VALUATION METRICS One of the most common metrics used in the Market Approach to a business valuation is a multiple of EBITDA. Currently, when an entity leases equipment or vehicles, the lease is typically structured to meet the criteria as an operating lease. Thus, the lease liability is off balance sheet. The new standard will not only require recognition of the lease liability and right-of-use asset, but will change how rent expense is recorded for finance leases. This will have an effect on EBITDA. Assume the same facts as in the first year of the equipment finance lease example shown on Table 3 and compare the effect on net income to a lease that is currently treated as an operating lease (Table 4: Current Operating Lease). TABLE 4: CURRENT OPERATING LEASE Current Operating New Finance Lease Lease Accounting Accounting Income $1,000,000 $1,000,000 Expense Rent 60,000 - Depreciation 20,000 20,000 Amortization 45,036 Other operating 730, ,000 Total expense 810, ,036 Net operating income 190, ,964 Interest expense 26,100 Net income 190, ,864 Income 76,000 71,546 Net income after tax $114,000 $107,318 9

5 Net income is lower because the total of amortization and interest ($71,136) is greater than the cash amount paid out in rent ($60,000) in the first year of the lease. The total interest and amortization will decrease each year of the lease as the liability is paid down creating fluctuation in income. This has an effect on EBITDA as shown in Table 5. TABLE 5: EBITDA EXAMPLE* EBITDA Calculation Current Operating Lease New Finance Lease Net income $114,000 $107,318 Interest - 26,100 Income tax 76,000 71,546 Depreciation 20,000 20,000 Amortization - 45,036 EBITDA $210,000 $270,000 * adjusted for owner s compensation) divided by MVIC (adjusted for seller-financing and P/L date lag) plus g of 3.63 percent (being 1.25 percent real growth and 2.38 percent average inflation as employed by IPCPL at the time. Assuming an EBIDTA multiple of four, the value would be $840,000 before any adjustments under current accounting as opposed to $1,080,000 if the new lease standard were in effect. The company is not worth more because of an accounting change. For many companies, capitalizing finance leases will not have a material effect on the income statement. However, those companies that lease a large dollar amount of equipment could see a dramatic swing in EBITDA. EBITDA multiples from Pratts Stats are based on historic sales of companies. As stated above, many companies structured leases to avoid capital lease treatment and rental expense on these leases would have been included in net income. Many private companies do not report income on a GAAP basis. They use income tax accounting or other special purpose frameworks and leases on those income statements included in the database most likely were not capitalized. Once the new leases standard is adopted, will historic EBITDA multiples be meaningful for valuation purposes? Or will valuation analysts have to uncapitalize finance leases in order to use historic EBITDA? The importance of the EBITDA metric was pointed out to the Board in meetings and in comment letters on the exposure drafts. Constituents generally agreed with recording lease assets and liabilities but argued against the income statement treatment for finance leases in that it affected EBITDA. The Board did compromise somewhat in allowing the expense for operating leases to be presented as part of operating income. THE BALANCE SHEET AND EFFECT ON FREE CASH FLOW TO EQUITY In transition to the lease standard, lessees are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach. There are a number of practical expedients dealing with the identification and classification of leases that commenced before the effective date which must be adopted as a package. 9 To illustrate the effect the standard will have on the financial statements, assume the following: A private company entered into a ten-year office lease on January 1, 2016, which is classified as an operating lease. There are no initial costs and the lease payments are constant through the lease at $60,000 per year. After transition to the new standard, the Company would continue to recognize rent expense of $60,000 per year. Assume the Company adopts the standard on January 1, 2020, and presents two-year comparative financial statements. Using the lease amortization schedule above, the lease payable at the beginning of the earliest period presented (January 1, 2019) is $342,265 (Year Four). The Company recognizes a right-of-use asset and lease payable in this amount. Assume the Company purchased $60,000 of computer equipment in 2014 and is depreciating it over five years on a straight line basis. At the beginning of 2019, the Company replaced the fully depreciated equipment and replaced it with $60,000 of equipment under a five-year lease payable at $1,000 per month. The lease is classified as a finance lease. The Company determines that the interest rate implicit in the lease is six percent and computes the present value at the beginning of the lease as $51,725. Under the accounting for a finance lease, the annual amortization is $10,345 ($51,725/5) and interest expense is recognized based on an amortization schedule. 9 Ibid. Section f and g. 10

6 Assume that in 2016 the Company purchased $40,000 of equipment depreciating it over five years on a straight line basis so that it is fully depreciated in The Company s income statements for the years 2016 to 2020 are shown in Table 6. The income and expenses other than depreciation, amortization, interest, and income taxes are presumed to remain constant for sake of illustration. TABLE 6: THE COMPANY S INCOME STATEMENTS Sales revenue: Sales 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 General and administrative expenses: Depreciation expense 20,000 20,000 20,000 8,000 8,000 Amortization expense ,345 10,345 Rents paid 60,000 60,000 60,000 60,000 60,000 Other operating 730, , , , ,000 Total G&A expenses 810, , , , ,345 Income from 190, , , , ,655 operations Less: interest expense ,855 2,291 Income before taxes 190, , , , ,364 Income 76,000 76,000 76,000 75,500 75,750 Net income 114, , , , ,614 BALANCE SHEETS The Company s balance sheets for 2016 to 2020 are as shown on Table 7. To illustrate the effect of the leases standard, the assets and liabilities other than fixed assets and leases payable are kept constant. For cash flow purposes, it is assumed that cash flows were paid out as dividends. The leases standard is specific as to presentation. It requires that finance lease right-of-use assets and operating lease right-of-use assets should be presented separately or disclosed in the notes. Finance lease liabilities and operating lease liabilities should be presented separately from each other and from other liabilities or disclosed in the notes. The right of use assets and liabilities shall be subject to the same consideration as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent Ibid. Section

7 TABLE 7: COMPANY BALANCE SHEET Assets Current assets: Cash 100, , , , ,000 Trade accounts receivable 250, , , , ,000 Total current assets 350, , , , ,000 Fixed assets: Equipment 100, , ,000 40,000 40,000 (Accumulated depreciation) (44,000) (64,000) (84,000) (32,000) (40,000) Right-of-use asset equipment ,725 51,725 (Accumulated amortization) (10,345) (20,690) Right-of-use asset office space , ,628 Net fixed assets 56,000 36,000 16, , ,663 Total assets 406, , , , ,663 Liabilities and stockholders equity Current liabilities: Trade accounts payable 75,000 75,000 75,000 75,000 75,000 Current portion equipment ,710 10,308 lease payable Current portion of office lease 43,070 45,726 payable Total current liabilities 75,000 75,000 75, , ,034 Long-term debt: Lease payable office , ,902 Lease payable equipment ,870 22,562 Total long-term debt , ,464 Total liabilities 75,000 75,000 75, , ,498 Stockholders equity: Common stock 100, , , , ,000 Retained earnings 231, , , , ,165 Total stockholders equity 331, , , , ,165 Total liabilities & stockholders equity 406, , , , ,663 With the addition of the right-of-use assets and related leases payable, the balance sheet has changed dramatically. The current ratio dropped from 4.67 to 2.74 between 2018 and The debt to equity ratio increased from 0.26 to 1.48 from 2018 to For valuations performed in the years that the leases standard is being phased in, variances when comparing the company s ratios to historic industry ratios will most likely need to be investigated. 13

8 Much has already been written about a company s need to review debt covenants before the effective date of the lease if it has significant leasing activity. FREE CASH FLOW TO EQUITY Despite capitalizing the leases and adding the related debt to the balance sheet, Free Cash Flow to Equity, Table 8, remains fairly constant in this example as seen below. This is not surprising since the new accounting for leases has not significantly changed the cash flow. The decrease in Free Cash Flow to Equity in this example is caused by the cash outlay required by the equipment lease which replaces an asset that had no associated debt. The cash paid out for the lease obligations is not affected by how the lease is classified. TABLE 8: EQUITY NET CASH FLOWS (FCF-EQUITY) Net income 114, , , ,614 Plus: depreciation 20,000 20,000 8,000 8,000 Less: acquisition of right-of-use ,725 asset equipment Plus: amortization of right-of-use 10,345 10,345 asset equipment Less: acquisition of right-of-use 342,265 asset office space Plus: amortization of right-of-use 40,567 43,070 asset office space Less: non-cash changes in net working capital Plus: changes in current leases ,780 3,254 payable Plus: changes in long-term leases ,498 (56,034) payable Equity net cash flows 134, , , ,249 Note that working capital was kept constant in this example so there are no changes. CONCLUSION Until companies fully adopt the new leases standard, it is hard to predict how the metrics used in business valuations will change. Obviously, companies such as retail chains and airlines that make heavy use of leases will see the most change in their financial statements. Smaller companies with a longer term office lease will see a large liability offset by a like right-of-use asset on their balance sheets. EBITDA multiples based on historic sale data may not be a reliable indicator of value. EBITDA multiples may also be affected by the new revenue recognition standard that could change net income. Business valuation analysts may place more reliance on the Income Approach since cash flows will not be greatly changed as a result of either of the new standards. As stated above, the new leases standard is complex and the effective date is still several years out, but it is not too early to think about the possible effects on business valuations. VE Judith H. O Dell, CPA CVA, is President of O Dell Valuation Consulting LLC. She has over forty years of public accounting experience. Since 2002, her practice has been limited to business valuation, forensic, and litigation support services. From 2007 to 2012, she served as chair of FASB s Private Company Financial Reporting Committee (PCFRC). The PCFRC provided input to the leases standard in its various iterations and many of the Committees recommendations regarding private company issues found their way into the final standard. She was named one of Accounting Today s Top 100 Most Influential People from 2007 to She received the AICPA Special Recognition Award and Case Western Reserve University s Braden Award in 2014 for her work on behalf of private company financial reporting. jodell@odellvalue.com 14