There’s been much talk surrounding the new leasing standard that has already taken effect for publicly traded companies and looms over privately held companies for periods beginning after December 15, 2019. One of the most anticipated standards the Financial Accounting Standards Board (FASB) has issued in the last 20 years, Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) requires all operating leases to be recorded on the balance sheet by recording a right-of-use asset and a lease liability. Capital leases (known as finance leases under ASU 2016-02) will continue to be treated similar to debt.
But the new standard has broader implications beyond adding an asset and liability to an entity’s balance sheet. The new leasing standard could very well impact the purchase/sale price of a company when EBITDA (earnings before interest, tax, depreciation and amortization) is used as a metric of business performance. Under ASU 2016-02, finance leases and assets purchased with debt would record amortization and/or interest expense, while operating leases would record lease expense. Although titled lease expense on the income statement, it consists of a combination of the amortization of the right-of-use asset and the interest growth of the liability. EBITDA would stay the same as it was under the old standard if the new lease expense is treated the same as the old rent expense. EBITDA would increase if lease expense is treated as amortization and interest. Whether or not this financial ratio is impacted by the implementation of the new lease standard will depend on the definition of EBITDA in the specific agreement governing the transaction.
The chart below highlights the impact of the new standard on an entity’s financial statement information, based on whether the entity enters an operating or finance lease, or purchases the asset with debt.
|Operating Lease||Lease Expense,
Depreciation of Asset
|Could Impact EBITDA — Depends on how “lease expense” is treated||Right-of-Use Asset||Lease Liability|
|Finance Lease||Interest Expense,
Depreciation of Asset
|No EBITDA Impact||Right-of-Use Asset||Lease Liability|
|Purchase with Debt||Interest Expense, Depreciation of Asset||No EBITDA Impact||Purchased Asset||Debt Liability|
So, while the income statement treatment of operating leases has not changed, the fact that operating leases are now required to be recorded on the balance sheet could very well cause entities, particularly those looking to sell in the near future, to structure new leases as financing leases or to simply purchase the asset with debt instead.
Business owners and investors must understand the type of leases recorded on the balance sheet as they make decisions for operating the business, and when considering buying or selling one. If your key metric for the business is EBITDA — which is how many private equity firms/family offices and banks gauge performance — structuring leases so the expense is classified as amortization and interest expense (finance lease) rather than lease expense (operating lease) will create value for the company in the eyes of investors.
Obviously, when deciding to enter into a lease or purchase an asset, you and your organization must take into account the comprehensive impact of that decision — with the impact on EBITDA being just one of the considerations.
Please contact a member of your service team, or contact Phil Ryan at email@example.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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