A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

VALUATION • How the New Leases Standard May Impact Business Valuations •

By Judith H. O’Dell, CPA, CVA

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

and liabilities that arise from leases. For leases with a term of 1 FASB Accounting Standards Codification 842-10-25-2.

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underlying asset that the lessee is reasonably certain lower risk free rate will most likely result in greater right- to exercise. of-use asset and lease liability. •• The lease term is for the major part of the remaining •• The right-of-use asset which shall consist of the amount of economic life of the underlying asset. the initial measurement of the lease liability, plus any lease •• The present value of the sum of the lease payments and any payments made to the lessor before the commencement residual value guaranteed by the lessee equals or exceeds of the lease minus any lease incentives received plus any substantially all of the fair value of the underlying asset. initial direct costs incurred by the lessee.4 •• The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the SUBSEQUENT MEASUREMENT end of the lease term. The lease liability is measured by increasing the carrying •• If none of the criteria are met, a lessee shall classify the amount to reflect on the lease liability and reducing lease as an operating lease. From a practical standpoint, the carrying amount to reflect the lease payments made leases of office and retail space will most likely meet the during the period. The lessee shall determine the interest criteria of an operating lease while leases of equipment and on the lease liability in each period during the lease term vehicles will most likely meet the criteria of a finance lease. as the amount that produces a periodic discount rate on the remaining balance of the liability, taking into account reassessment requirements.5 Many private companies lease real estate and/or equipment from related parties and in many cases there are no formal For an operating lease, a single lease cost is recognized, leases. The standard states that leases between related calculated so the cost of the lease is allocated over the lease parties should be classified in accordance with the lease term on generally straight line basis. The expense is included classification applicable to all other leases on the basis of the in the lessee’s income from continuing operations.6 legally enforceable terms and conditions of the lease.2 The The right-of-use asset for a finance lease is amortized on a Basis for Conclusions (BC374) recognizes that some leases straight line basis (unless another systematic basis is more are not documented, and/or terms and conditions are not at representative of the pattern of use) from the commencement arm’s length. Valuation analysts usually normalize income date to the earlier of the end of the life of the right-to-use statements to include a fair market basis rent. The balance asset or the end of the lease term.7 Unlike an operating lease, sheet may need to be normalized to include a right-of-use the interest expense on the lease liability and amortization asset and related liability once the standard is effective. of the right of use asset are presented in a manner consistent INITIAL MEASUREMENT with how the entity presents other interest expense and At the commencement date, a lessee shall measure both of depreciation or amortization of similar assets, respectively.8 3 the following: FINANCE LEASE EXAMPLE •• The lease liability at the present value of the lease payments A lessee enters into a ten-year lease of a piece of equipment. not yet paid discounted using the discount rate for the There are no initial direct costs, variable payments or other lease. The discount rate is based on information available increases. The total rent is $600,000. The annual rent is at the commencement date and can be the rate implicit $60,000 per year payable at $5,000 per month. The rate in the lease. If this rate is not readily determinable, then implicit in the lease is not readily determinable. The lessee’s the lessee uses its incremental borrowing rate. There is a incremental borrowing rate is six percent. The present value special provision for private companies that do not have of the $5,000 monthly lease payment is $450,367 as shown an incremental borrowing rate to use a risk free discount rate as an accounting policy election. However, use of the 4 Ibid. 842-20-30-5. 5 Ibid. 842-20-35-1. 6 Ibid. 842-20-45-4. 2 Ibid. Section 842-10-55-12. 7 Ibid. 842-20-35-7 and 8. 3 Ibid. 842-20-30-1 through 3. 8 Ibid. 842-20-45-4.

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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

Beginning Ending Year Interest Payment Principal Balance Balance 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 $54,719 10 $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

Cash 60,000

Amortization 45,036

Right-of-use asset 45,036

Interest expense 26,100

Lease payable 26,100 Year-end balances

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).

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At the end of the first year, the lessee adds $26,100 of interest payment are deducted so that the liability of $416,467 equals to the liability balance and subtracts the $60,000 payments the right-of-use asset. The year-end balance of the liability made, leaving a balance of $416,467. is the same for both finance and operating leases in this example, but the right-of-use asset is not. Note that in this Note that while the annual lease payment is $60,000, the total simple operating lease example, rent expense is constant expense recognized for interest and amortization is $71,136; throughout the life of the lease and does not take into account this amount will decrease each year though the life of the lease. any scheduled increases or variable payments. The standard The results are somewhat similar to depreciation and interest describes, in detail, how these are to be accounted for. expense as if the asset had been purchased and financed. EFFECTS ON METRICS OPERATING LEASE EXAMPLE One of the most common metrics used in the Market Assume the same facts as above except that the lease is for Approach to a business valuation is a multiple of EBITDA. office space and meets the criteria for an operating lease. In Currently, when an entity leases equipment or vehicles, this case, the annual rent expense is $60,000. It would be the lease is typically structured to meet the criteria as an included within income from continuing operations, most operating lease. Thus, the lease liability is off balance sheet. likely classified as rent expense. The new standard will not only require recognition of the The entity would make the following entries, shown on lease liability and right-of-use asset, but will change how Table 3. “rent expense” is recorded for finance leases. This will have an effect on EBITDA. TABLE 3: OPERATING LEASE EXAMPLE* Assume the same facts as in the first year of the equipment Operating Lease Debit Credit finance lease example shown on Table 3 and compare the effect on net income to a lease that is currently treated as an Right-of-use operating lease (Table 4: Current Operating Lease). 1/1/xxxx asset 450,367

Lease payable 450,367 TABLE 4: CURRENT OPERATING LEASE End of first year (would be monthly entries) Current Operating New Finance Rent expense 60,000 Lease Lease Cash 60,000 Accounting Accounting Right-of-use Income $1,000,000 $1,000,000 asset 33,900 Expense Lease payable 33,900 Rent Year-end balance 60,000 - Depreciation Right-of-use 20,000 20,000 Amortization asset 416,467 45,036 Other operating Lease payable 416,467 730,000 730,000 Total expense Rent expense 60,000 810,000 795,036 Net operating *MVIC adjusted by BB&D to compensate for seller-financing and income 190,000 204,964 difference between firm profit/loss reporting date vs. Transaction date. Interest expense 26,100

Net income 190,000 178,864 The right-of-use asset is calculated at the original amount Income tax @40% of $450,367 less the rent of $60,000 plus interest expense of 76,000 71,546 $26,100 for a total of $416,467. Interest expense of $26,100 Net income after is added to the initial lease liability of $450,367 and the rent tax $114,000 $107,318

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Net income is lower because the total of amortization and The importance of the EBITDA metric was pointed out to the interest ($71,136) is greater than the cash amount paid out in Board in meetings and in comment letters on the exposure rent ($60,000) in the first year of the lease. The total interest drafts. Constituents generally agreed with recording lease and amortization will decrease each year of the lease as the assets and liabilities but argued against the income statement liability is paid down creating fluctuation in income. treatment for finance leases in that it affected EBITDA. The Board did compromise somewhat in allowing the expense for This has an effect on EBITDA as shown in Table 5. operating leases to be presented as part of operating income. THE BALANCE SHEET AND EFFECT ON FREE TABLE 5: EBITDA EXAMPLE* CASH FLOW TO EQUITY In transition to the lease standard, lessees are required to Current recognize and measure leases at the beginning of the earliest EBITDA Operating New Finance period presented using a modified retrospective approach. Calculation Lease Lease There are a number of practical expedients dealing with the identification and classification of leases that commenced Net income $114,000 $107,318 before the effective date which must be adopted as a package.9 Interest - 26,100 To illustrate the effect the standard will have on the financial Income tax 76,000 71,546 statements, assume the following: Depreciation 20,000 20,000 •• A private company entered into a ten-year office lease Amortization - 45,036 on January 1, 2016, which is classified as an operating EBITDA $210,000 $270,000 lease. There are no initial costs and the lease payments * adjusted for owner’s compensation) divided by MVIC (adjusted for are constant through the lease at $60,000 per year. After seller-financing and P/L date lag) plus “g” of 3.63 percent (being 1.25 transition to the new standard, the Company would continue percent real growth and 2.38 percent average inflation as employed by to recognize rent expense of $60,000 per year. Assume the IPCPL at the time. Company adopts the standard on January 1, 2020, and Assuming an EBIDTA multiple of four, the value would be presents two-year comparative financial statements. Using $840,000 before any adjustments under current accounting the lease amortization schedule above, the lease payable at as opposed to $1,080,000 if the new lease standard were the beginning of the earliest period presented (January 1, in effect. The company is not worth more because of an 2019) is $342,265 (Year Four). The Company recognizes a accounting change. For many companies, capitalizing finance right-of-use asset and lease payable in this amount. • leases will not have a material effect on the income statement. • Assume the Company purchased $60,000 of computer However, those companies that lease a large dollar amount of equipment in 2014 and is depreciating it over five years equipment could see a dramatic swing in EBITDA. on a straight line basis. At the beginning of 2019, the Company replaced the fully depreciated equipment and EBITDA multiples from Pratts Stats are based on historic sales replaced it with $60,000 of equipment under a five-year of companies. As stated above, many companies structured lease payable at $1,000 per month. The lease is classified as leases to avoid capital lease treatment and rental expense on a finance lease. The Company determines that the interest these leases would have been included in net income. Many rate implicit in the lease is six percent and computes the private companies do not report income on a GAAP basis. present value at the beginning of the lease as $51,725. Under They use income tax accounting or other special purpose the accounting for a finance lease, the annual amortization frameworks and leases on those income statements included is $10,345 ($51,725/5) and interest expense is recognized in the database most likely were not capitalized. Once the new based on an amortization schedule. 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? 9 Ibid. Section 842-10-65-1f and g.

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•• 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 2020.

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

2016 2017 2018 2019 2020 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 0 0 0 10,345 10,345 Rents paid 60,000 60,000 60,000 60,000 60,000 Other operating 730,000 730,000 730,000 730,000 730,000 Total G&A expenses 810,000 810,000 810,000 808,345 808,345 Income from 190,000 190,000 190,000 191,655 191,655 operations Less: interest expense 0 0 0 2,855 2,291 Income before taxes 190,000 190,000 190,000 188,800 189,364 Income tax @40% 76,000 76,000 76,000 75,500 75,750 Net income 114,000 114,000 114,000 113,300 113,614

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. 10

10 Ibid. Section 842-20-745-1.

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TABLE 7: COMPANY BALANCE SHEET

2016 2017 2018 2019 2020

Assets Current assets: Cash 100,000 100,000 100,000 100,000 100,000 Trade accounts receivable 250,000 250,000 250,000 250,000 250,000 Total current assets 350,000 350,000 350,000 350,000 350,000 Fixed assets: Equipment 100,000 100,000 100,000 40,000 40,000 (Accumulated depreciation) (44,000) (64,000) (84,000) (32,000) (40,000) Right-of-use asset—equipment 0 0 0 51,725 51,725 (Accumulated amortization) (10,345) (20,690) Right-of-use asset—office space 0 0 0 301,698 258,628 Net fixed assets 56,000 36,000 16,000 351,078 289,663 Total assets 406,000 386,000 366,000 701,078 639,663 Liabilities and stockholders’ equity Current liabilities: Trade accounts payable 75,000 75,000 75,000 75,000 75,000 Current portion equipment 0 0 0 9,710 10,308 lease payable Current portion of office lease 43,070 45,726 payable Total current liabilities 75,000 75,000 75,000 127,780 131,034 Long-term debt: Lease payable—office 0 0 0 258,628 212,902 Lease payable—equipment 0 0 0 32,870 22,562 Total long-term debt 0 0 0 291,498 235,464 Total liabilities 75,000 75,000 75,000 419,278 366,498 Stockholders’ equity: Common 100,000 100,000 100,000 100,000 100,000 Retained earnings 231,000 211,000 191,000 181,800 173,165 Total stockholders’ equity 331,000 311,000 291,000 281,800 273,165 Total liabilities & stockhold- 406,000 386,000 366,000 701,078 639,663 ers’ equity 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 2019. The debt to equity ratio increased from 0.26 to 1.48 from 2018 to 2019. 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.

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Much has already been written about a company’s need to review debt covenants that could change net income. Business before the effective date of the lease if it has significant leasing activity. valuation analysts may place more reliance on the Income Approach since TO EQUITY cash flows will not be greatly changed as Despite capitalizing the leases and adding the related debt to the balance sheet, Free a result of either of the new standards. Cash Flow to Equity, Table 8, remains fairly constant in this example as seen below. As stated above, the new leases standard This is not surprising since the new accounting for leases has not significantly is complex and the effective date is still changed the cash flow. The decrease in in this example several years out, but it is not too early is caused by the cash outlay required by the equipment lease which replaces an to think about the possible effects on asset that had no associated debt. The cash paid out for the lease obligations is not business valuations. VE affected by how the lease is classified. TABLE 8: EQUITY NET CASH FLOWS (FCF-EQUITY) Judith H. O’Dell, CPA

2017 2018 2019 2020 CVA, is President of O’Dell Valuation Con- Net income 114,000 114,000 113,300 113,614 sulting LLC. She has Plus: depreciation 20,000 20,000 8,000 8,000 over forty years of public Less: acquisition of right-of-use 0 0 51,725 accounting experience. asset—equipment Since 2002, her practice Plus: amortization of right-of-use 10,345 10,345 has been limited to business valuation, asset—equipment forensic, and litigation support services. From 2007 to 2012, she served as chair Less: acquisition of right-of-use 342,265 of FASB’s Private Company Financial asset—office space Reporting Committee (PCFRC). The Plus: amortization of right-of-use 40,567 43,070 PCFRC provided input to the leases asset—office space standard in its various iterations and Less: non-cash changes in net 0 0 0 0 many of the Committees recommenda- tions regarding private company issues Plus: changes in current leases 0 0 52,780 3,254 found their way into the final stan- payable dard. She was named one of Account- Plus: changes in long-term leases 0 0 291,498 (56,034) ing Today’s Top 100 Most Influential payable People from 2007 to 2011. She received the AICPA Special Recognition Award Equity net cash flows 134,000 134,000 122,500 122,249 and Case Western Reserve University’s Note that working capital was kept constant in this example so there are no Braden Award in 2014 for her work on changes. behalf of private company financial re- porting. E-mail: [email protected] 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

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