You better pack a lunch!
With the ASC842 compliance deadline less than 9 months out, there is still massive confusion around the net impact for C-Suite executives in regards to what’s the cost of achieving compliance. The direct costs of achieving compliance require less interpretation than do the indirect costs, which are more futuristic, speculative, and largely based on projections. ASC842 Lease Compliance – Valuation as a Service, is designed to help compliance decision-makers with an understanding of the ‘edge’ components that do not necessarily reflect process or system changes, but to everything else in between running a compliant lease portfolio, as well as the financial impact of the lease compliance initiative from a financial performance perspective.
The most important data element in the compliance process for CEO’s is the impact on Company valuation – with a projected impact of over 2 Trillion dollars, being shifted from footnotes to balance sheets, all with the intention to help investors by providing visibility into financial performance at a deeper level – even down to the asset-liability level, which has not previously been exposed to investors.
While ASC 842 may provide investors and other financial statement users with new information, and may enhance the comparability between similar businesses, the adoption of any new accounting standard should not create or destroy value. Thus, the recognition of new assets and liabilities on corporate balance sheets requires a reorientation of valuation models
Understanding Valuation impact
Investors and valuation professionals alike frequently determine a company’s value on an enterprise basis. The value of a company pre-ASC842 will be different than the value of the company post-ASC842, as you are basically adding debt to the balance sheet, which was not recorded in the previous year’s reporting. Enterprise value represents the total invested capital of a business, including common and preferred equity and interest-bearing debt.
Treating operating lease liabilities as debt-like requires a reorientation in thinking. Importantly, the corporate debt and equity pie is not further subdivided but rather expanded. To distinguish between the two, the traditional definition of enterprise value is referred to hereinafter as “net EV” (NEV, net of lease liabilities), and enterprise value inclusive of operating lease liabilities is referred to as “gross EV” (GEV, gross of lease liabilities), as illustrated in Figure 2.
ASC842 Lease Accounting Impact on Stock Price
The initial recognition of operating leases on balance sheets has led to many companies’ share prices to drop as they begin adhering to the new lease accounting standard and companies with significant operating leases lost stock value, on average, during the quarter in which they first recognized those leases, according to a study conducted by researchers at Florida International University.
Before the rule, which started going into effect in December 2018, public companies used to disclose operating leases in the footnotes of their financial statements. By implementing the new ASC842 lease accounting standards, companies’ liabilities are now out of proportion with their previously submitted balance sheets – which is creating a market reaction that is negatively influencing their stock price and corporate valuation. The challenge with this situation is that it disproportionately affects those industries with a higher percentage of operating leases, so Retail, Transportation, and Consumer Services now are at a disadvantage, compared to other verticals – as they are operating lease intensive. The intentions of this compliance mandate come from a good place, as it is aimed at transparency for lenders and investors. – WSJ
ASC842 Technical Accounting Impact: EBITDA
A multiples-based valuation approach draws comparisons between price and performance. For example, price-to-earnings (P/E) ratios compare equity prices per share to earnings (net income) per share. From an enterprise value perspective, the most widely used valuation multiple is enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA). Importantly, when deriving and applying valuation multiples, the numerator and denominator of the multiple equations must be presented on the same basis. That is, because enterprise value reflects a debt-free measurement, it must be divided by a debt-free measure of earnings. Similarly, because equity value is measured after the consideration of debt, it must be divided by a measure of earnings that deducts interest on that debt.
This same construct extends to analyzing leases in a valuation multiple contexts. Theoretically, NEV reflects a company’s value after deducting operating lease obligations, and therefore, NEV is divided by EBITDA, which includes a deduction for the rent expense. If, instead, we measure a company’s value on a GEV basis (gross of lease liabilities), the appropriate earnings metric to consider is EBITDA before rent (EBITDAR). In doing so, GEV is presented prior to the consideration of either finance or operating leases, and likewise, EBITDAR is consistently presented prior to the consideration of rent on operating leases or interest and depreciation on finance leases. The diagram below provides the mathematical model for determining the impact on EBITDA, which will be reduced because of the addition of the interest and lease liability additions to the balance sheet – which will also reduce company value/valuation – Stout:
Net EV (Equity-Cash+Traditional Debt+Finance Lease Liabilities
EBITDA
(Gross EV (Equity-Cash+Traditional Debt+Finance Lease Liabilities+Operating Lease Liabilities))
(EBITDA+Rent)
The need for an expert to help apply the lease compliance changes to your lease portfolio and correctly update your balance sheet is mandatory. Unfortunately, many try the DIY model, using spreadsheets and accounting resources who do not possess the Lease Accounting experience necessary to make these impactful changes. We at Leaseology, have a team of veteran technical accountants that are crucial in helping our customers to maximize their stated value, correctly apply the compliance rules to lease portfolios and achieve compliance, and highly recommend leveraging our laser-focused team members, as the risk of getting this wrong is not worth the convenience of using under-skilled resources. Leveraging the right resources allows CFO’s to sleep at night. Are you sleeping?
ASC842 Compliance impact on Valuations and Private Equity
Achieving ASC842 compliance provides a correct valuation, removes penalties for being out of compliance, and above all else – it creates opportunity. The opportunity that compliance creates is in being ‘ready’ for either a divestiture or Acquisition, as the last thing investors want is to try and figure out your lease portfolio, review leases, analyze the EBITDA impact and build a platform for you. Audit fees are obscene, and the lack of compliance will create the need to fill in this gap, with seasoned auditors – and this is a huge time/cost impediment that investors will run from.
The option that is catching fire is – outsource!
This is no business’s core competency, they are only doing it because they have to. The reason lease compliance as a service is trending currently, is because it’s a simple, consolidated solution that does not require a massive RFP process, full of vendor panel interviews, presentations, hardened – cross-departmental requirements, deep forensic audit analysis, or buying software. Get rid of the business distraction and move to a service, that can handle all this for you, and make it easy for the PE folks to say ‘yes’, to an exit/merger or some other flavor of opportunity.
A compliant target makes it easy to establish valuation and provides the transactional agility they seek, as market conditions are unpredictable and can fluctuate wildly.
The team at Leaseology has a similar perspective on the importance of compliance, we just have extensive field experience in providing these types of solutions, and like any good group of former consultants, we only build solutions that we would want to use if we were in our customer’s shoes. When you know the content at the expert level, you know where to look for RISK, which manifests itself as: Evergreen leases (paying for property/equipment that you are no longer utilizing), Lost cash flow opportunities on the renegotiation and subletting of commercial real estate – Covid response, as well as EBITDA, balance sheet impact.
How COVID has transformed Lease Accounting?
Agility is a by-product of COVID, which will create unparalleled opportunities for financial expansion, as the weak are consumed by the profitable. Lease Managed Services is the key benefactor in the race for compliance, as the COVID distraction and financial ramifications have made the Q4 deadline almost unattainable. Leaseology is ramping up for the end-of-year frenzy, as customers are quickly realizing the complexities of the task a hand.
ASC842 Lease Compliance – Valuation as a Service
Key Takeaways
- Manual Lease Accounting guarantees risk– leverage a Lease Managed Service provider, who can support each of the key milestones needed to achieve compliance
- Auditors are a distant second option, and you’re not going to like their bill rates
- Lease Accounting subscriptions enable customers to avoid death by audit fees while providing a comprehensive service, experts to advise and a solution that is void of any peripheral IT support or maintenance costs.
- Call Leaseology, we can take the sting out of this complex compliance obstacle
Leaseology understands what internal lease accounting teams are up against, and has built an end-to-end solution that allows customers to divert resources, remove cost, increase accuracy/locate cost savings opportunities – all while achieving compliance via an outsourced lease management process. The following six pillars of success are the core of the Leaseology service offering, and we are confident that our combination of industry expertise in lease accounting, compliance, reporting, and automation can help you meet the ASC842 compliance requirements.
Leaseology, Inc is a North America-based business advisory services firm committed to accelerated marketplace adoption of digital technology, financial management innovation, and business operations practice excellence. These core competencies apply to real estate and equipment portfolios.
