What Changes to the Lease Accounting Standards Means for Business Valuation

Accounting Standards Codification (ASC) Topic 842: Leases is the lease accounting standard published by the Financial Accounting Standards Board, which replaces prior guidance from ASC Topic 840. ASC 842 brings previously off-balance sheet operating leases onto a company’s balance sheet. The new standard takes effect for private companies in fiscal years starting after December 15, 2021, and represents a fundamental change to financial statements, which are the foundation of business valuation analyses. This article will focus on potential impacts to a valuation analysis as a result of the change in accounting standards.

Basics of Leases in Financial Statements

Under ASC 842, there are two lease classifications: operating leases and financing leases.¹ The income statement and the statement of cash flows are largely unchanged under the new accounting standard. Companies will continue to expense operating leases on a straight-line basis on the income statement and companies will continue to report financing leases interest expense on the income statement.

In the statement of cash flows, operating leases will be included in the operating activities section. For financing leases, the principal payment on the lease will be included in the financing activities section and the interest portion in operating activities section. With respect to the balance sheet, the treatment of financing leases is substantially similar to that of capital leases under previous guidance (asset and liability included); however, the treatment of operating leases substantially changes the reporting from previous guidance.

Prior to ASC 842, operating leases were not required to be recorded on the face of a company’s financial statements, they only had to be included in the notes. Under ASC 842, operating leases are now recorded on the balance sheet and reflected as a “right-of-use” asset and as a corresponding operating lease liability, which will typically offset at lease initiation.

Financial and Valuation Analysis Impacts

To develop valuations for privately held companies, analysts typically consider three general approaches: an income approach, a market approach, and an asset approach. The asset approach, which arrives at a value by subtracting liabilities from assets, is largely unchanged under ASC 842. As such, the focus of this article is the impact to valuation analysis under the income and market approaches and the related financial analysis.

For the purposes of financial statement and valuation analyses of companies reporting under ASC 842, an analyst must determine whether to view operating leases as debt-like liabilities² or off-balance sheet liabilities consistent with historical accounting guidance. This decision is important because the change in balance sheet presentation under ASC 842 could impact the analysis of trends in a company’s financial condition over time. Further, business valuation is often performed on a pre-debt basis — i.e., an analyst first arrives at the value to both debt and equity holders (enterprise value) by capitalizing or discounting free cash flow or applying multiples to earnings before interest, taxes, depreciation, and amortization (EBITDA). The analyst then subtracts debt, including balance sheet leases, to arrive at an equity value. As a result, how operating leases are treated influences free cash flow calculations, earnings metrics, and the enterprise value of public companies used to compute market multiples. Therefore, proper analytical treatments are required (under both the income and market approaches) to ensure an apples-to-apples comparison in developing a valuation.

Income Approach

As discussed above, the treatment of operating leases can influence both the calculation of cash flows and the weighted average cost of capital discount rate. Therefore, it is important to correctly match the treatment of operating leases across these different inputs to the income approach. Specifically, analysts should avoid double counting the impact of an operating lease liability in their analysis through inclusion or exclusion in both cash flows and debt. If the treatment of operating lease liabilities is double counted, value could be diminished because of a reduction in cash flows and subtraction of the operating lease debt, or overstated because of an increase in cash flows and failure to subtract the operating lease debt.

The income statement treatment for operating leases is similar to previous guidance and includes rent expenses. If an analyst treats an operating lease as a non-debt liability, consistent with prior accounting standards, no adjustments to the income statement or free cash flow for this item are required.

However, if operating leases are treated as debt-like, the analysis should align operating lease reporting with financing lease reporting. To make the adjustment, the free cash flows discounted or capitalized should exclude rent expenses. The analyst should also consider new operating leases in their calculation of free cash flow, similar to the treatment of capital expenditures. Additionally, if operating leases are treated as debt, the weighted average cost of the capital discount rate should reflect the balance and cost of the leases as a debt component of the overall capital structure. The rate can be determined by using the incremental borrowing rate or the rate implicit in the lease.

While the determination of the detailed calculation of free cash flow in each treatment, and the proper discount rate to be applied, is beyond the scope of this article, Marcum professionals have the experience and training to help companies determine the appropriate adjustments and rates to use.

Market Approach

The guideline public company method uses the enterprise values of publicly traded companies to develop valuation multiples. To highlight the impact of the changes from ASC 842, we will consider an enterprise value to EBITDA multiple. EBITDA will be different depending on whether an analyst treats the operating leases as debt or non-debt liabilities (note that this change does not significantly impact the calculation of EBIT or net income). If treating operating leases as debt, EBITDA should be computed by adding back related operating lease rent to arrive at EBITDAR. The following table illustrates the calculation of a public company multiple under each treatment of operating leases, assuming $10 million in operating lease liabilities and $2.5 million in related rent expenses.

The adjustment results in a comparable multiple in either scenario and allows an analyst to make an informed decision in the valuation of the subject company.

Conclusion

Changes in the accounting of leases should not generally impact a business valuation conclusion. However, because the treatment of operating leases can influence the calculation of cash flows, discount rates, and valuation multiples, appropriate consideration and adjustments to the calculations should be taken to ensure the valuation conclusion does not differ based on accounting treatment. While the financial and valuation analysis impacts are complex, you can consult with Marcum business valuation and litigation professionals who have the expertise to accurately adjust financial and valuation analyses for the new lease accounting standards.

Sources

1. One important note to this discussion is that this classification is only under U.S. GAAP, as IFRS does not include the dual classification system and only has the financing lease reporting.
2. This means an analyst would typically view the operating lease liability as debt and the offsetting right of use asset similar to property and equipment.