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Impending Lease Accounting Changes and Impact on Private Equity
The new lease accounting standard, which goes into effect in 2019 for private companies, is the most impactful reporting change since Sarbanes-Oxley in 2002. The standard itself is broad in scope and implementing it will be challenging for most companies. Read on to discover what the new accounting standard is and how we think it will impact private equity.
For the past 20 years, the SEC (Securities and Exchange Commission), FASB (Federal Accounting Standards Board) and the U.S. Congress have been implementing regulations to provide investors with greater transparency into the financial statements of public and private companies. They’ve had good reason. Remember Enron? Congress quickly enacted Sarbanes-Oxley in 2002 to protect investors from potential corporate fraud.
FASB’s new lease accounting standard – ASC 842 – has a similar objective: to bring greater transparency to how leases are accounted for. For private companies, beginning in 2019, all leases with terms greater than 12 months must be capitalized and reported on a company’s balance sheet.
“These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligation. The new standard will provide much needed transparency on companies’ lease assets and liabilities, meaning that off-balance sheet lease financing is no longer lurking in the shadows. It will also improve comparability between companies that lease and those that borrow to buy.”
INTERNATIONAL ACCOUNTING STANDARDS BOARD CHAIRMAN
No big deal, right? Think again.
FASB, which first introduced the lease accounting standards in 2016, warned companies not to wait until the last minute to prepare for the changes. Although 2019 seems far away, companies will need to provide side-by-side comparables to make the transition from old to new standards. This is an SEC requirement designed to make it easier for investors to understand the implication of the accounting change.
Proposed Changes to Leases
The lease accounting standard will dramatically change the financial reporting of nearly all businesses. The impact will be significant for private equity firms that utilize financial statement metrics to evaluate portfolio company investments. Key performance ratios such as the return on capital and leverage ratios will change with the addition of assets and liabilities to the balance sheet. The change could also trigger debt-covenant violations and lead creditors to scrutinize investments more closely.
The biggest change will be how leases are recognized on a company’s balance sheet. It will be important for the lessee and lessor to classify a lease at the onset as either an operating or finance lease as the accounting standards vary slightly.
Substantially, all long-term operating leases will now have a right-of-use asset and a lease liability on the balance sheet and record a straight-line expense on the income statement. Finance leases will also recognize a right-of-use asset and a lease liability but will recognize amortization of the asset and interest on the liability.
A summary of the accounting differences between operating and finance leases can be found below:
The lease classifications will be presented differently in the financial statements, affecting cash flow, balance sheet metrics, net income and EBITDA.
What are the Potential Ramifications and How to Prepare
The new accounting standards are likely to change the way investors fundamentally evaluate business opportunities through a change in key business metric calculations and more detailed disclosure requirements. The uniform standards will also eliminate industry specific guidelines and increase comparability across companies and industries. The impact, however, is likely to vary by industry.
Companies with large operating lease obligations will be the most impacted by the new accounting rules. Specifically companies in commercial real estate, transportation, construction, retail and consumer industries. Accounting Web outlined the ten companies to be most impacted by the new lease accounting standards in a recent article: Walgreens, AT&T, CVS, Walmart, FedEx, Bank of America, Verizon Communications, McDonald’s, United Continental Holdings and Delta Airlines.
There are a number of things firms can begin doing right away to prepare for the new accounting standards. The first is to get clarity on current systems and resources and establish a team and point person to guide the transition. Secondly, additional resources need to be identified for the team to collect and validate the information under the new standards. Thirdly, once implementation has begun, compliance gaps will need to identified, the impact on financial statements needs to be understood and new procedures need to be tested with updated data.
TresVista has provided support to its clients throughout this transition from a consultative and project management perspective and would be happy to speak with you about best practices.
Private equity firms need to prepare now to ensure their portfolio companies are moving towards compliance with the new accounting standard. Time is of the essence — companies have six months left to prepare for the new lease accounting standards.