Private equity investors, investment bankers and other professionals in the deal community have historically utilized EBITDA as a proxy for valuing a business during an acquisition or sale. The new lease standard, first issued by FASB in 2016, has possible implications that will affect this practice.
What is the new lease standard?
In 2016, FASB issued Topic 842, which covers leases and revised the effective date with ASU 2019-10. This update will be in effect for nonpublic entities for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021. Early adoption is permitted.
The update has the potential to impact EBITDA in some rare cases, and could also impact the initial metric often relied upon for valuation of a business acquisition. It is unlikely there will be a material impact, but proper due diligence should be performed.
How could the new lease standard impact EBITDA and business sales?
The old accounting standards from ASC 840 classified leases into two categories: operating lease and capital lease. Cash expenditures related to capital leases are excluded from EBITDA as they relate to debt payments, which reduce the lease liability and interest expense. The other expense component of the capital lease is amortization, which is related to the asset recorded on the balance sheet at the inception of the lease.
Under the old rules for operating leases, the expenses associated with these leases directly reduced EBITDA because they were classified as rent expense and recorded on the straight-line basis. (This will still be the same under the new lease rules.) The expenses were not recorded on the balance sheet, but the future minimum payments were disclosed in the footnotes to the financial statements.
The biggest change with the new lease rules is that operating leases will be required to be recorded on the balance sheet as a right of use (ROU) asset and a lease liability. One exception to this is if the lease is for 12 months or less with no intention to renew. Operating leases will now show debt (operating lease liability) on the balance sheet, and a potential buyer looking to make a cash-free, debt-free deal will want to take this into consideration when negotiating terms.
The new lease rules also eliminated the term “capital leases,” which are now considered to be finance leases. Previously, a capital lease was classified as such if the agreement met one of four specific criteria (outlined in the table below). These criteria are still used in determining a finance lease vs. an operating lease, but the rules are more principle-based and require more judgement to determine classification.
It is possible, although it would be uncommon, that an operating lease under the old rules could be classified as a finance lease under the new rules. As a result, this would increase EBITDA as expenses associated with a finance lease consist of amortization and interest expense, which are typically added back when calculating EBITDA. The update could also affect cash-free, debt-free transactions by increasing the amount of debt on the balance sheet.
|Old Lease Standards:
|1.) Ownership transfers at the end of the lease term.|
|2.) There is a bargain purchase option for the asset at the end of the term.|
|3.) The term of the lease is greater than or equal to 75% of the useful life of the asset.|
|4.) The present value of the lease payments is greater than or equal to 90% of the asset's fair market value.|
|New Lease Standards:
|1.) Ownership transfers at the end of the lease term.
|2.) There is a purchase option for the asset at the end of the term that the lessee intends to exercise.|
|3.) The term of the lease is a major part of the economic life of the asset.|
|4.) The present value of the lease payments is equal to substantially all of the fair value of the asset.|
|5.) The lease is for a specialized asset with no alternative use to the lessor.|
What changes do I need to make in relation to EBITDA and the new lease standard?
While it’s unlikely that EBITDA and value drivers will be significantly impacted by the new lease standard, we consider it important to perform proper financial due diligence related to leases. This can be done during typical buy-side or sell-side quality of earnings.
Business sales can be complicated.