It’s a common challenge: The balance sheet treatment of leases makes it difficult for private equity firms and other investors to accurately compare different acquisition targets. A portfolio company with substantial financing (formerly known as capital) lease obligations might appear highly leveraged, while another that is able to structure those commitments as operating leases and doesn’t put them on the balance sheet would look less so. The investment decision could be quite different if both companies had accounted for two similar leases in the same way.
A new rule, driven by investors and outlined by the Financial Accounting Standards Board (FASB), aims for more consistent presentation of leases across financial statements. Private equity firms and other investors will no longer have to use complex calculations to try to achieve comparability between companies that lease and those that borrow to buy.
Beginning in 2020, privately held entities must present the discounted present value of future lease payments on the balance sheet for leases that extend beyond one year. (Public companies must comply by 2019.) The new rule, established in February 2016, has far-reaching implications. A retail company alone could have thousands of lease agreements.
Most other companies also lease office or warehouse space, as well as equipment, for lengthy terms of as much as 10 years—and perhaps several additional years once renewal options are considered. The rule could dramatically impact the composition of such entities’ balance sheets, showcasing sizable liabilities that previously went unrecorded and thereby impacting leverage ratios and other financial metrics.
A problem for potential investors is determining how effective a company will be in implementing the rule. Companies that lack the needed expertise—or awareness that they must even comply—may leave private equity firms with a potentially expensive and time-consuming cleanup of a potential target company’s financials that would affect the company’s bottom line.
Any impact to the bottom line could in turn have an effect on employee compensation arrangements which take company profitability into account. It’s essential for a company to assess its ability to accommodate the FASB rule so all lease agreements are properly recorded.
Request All Lease Agreements
Private equity firms should obtain a summary of lease terms, and payment information from portfolio companies and potential target companies. This summary is referred to in real estate as a lease abstract, and the detail provided will help determine any gaps in compliance. Private equity firms should also consider how, if at all, the FASB rule might change companies’ behavior with respect to lease maturities, and whether they might opt for short-term leases instead.
Assess Accounting Technology
The new guidance requires extensive record keeping, so a target company or an existing portfolio company may need to invest in technology to properly monitor and track all lease agreements. Simply using an Excel spreadsheet could be a red flag. Companies should have lease accounting software that, if not integrated with their general ledgers, at the very least tracks and provides the right accounting under the new guidance.
Evaluate Accounting Staff and Audit Firms
Private equity firms should assess whether companies’ accounting staff and audit firms have the skills and technology background needed to apply the new standard. If they do not, additional training, hiring and possibly engaging outside consultants is needed in order to comply.
Establish a Steering Committee
Private equity firms should consider creating a steering committee, directing the appropriate project plan and timeline for portfolio companies to reasonably comply with the new standard. The roadmap should determine whether time and resources are sufficient to accommodate the new rule, whether new policies, procedures, and controls must be established and disclosed and to avoid any rushed actions ahead of the deadline.
Request a Pro Forma
A pro forma financial statement should lay out how leasing arrangements will be accounted for under the new standard. If the potential target is a foreign company that follows International Financial Reporting Standards, or IFRS, consider whether the pro forma should meet U.S. GAAP standards as there are some differences between the two standards.
Review Loan Covenants
The FASB rule’s potential impact on a company’s loan covenants is a critical detail that firms should be aware of. Any potential target company should go over the new leasing standard with lending institutions. The new rule could potentially result in a company violating a loan covenant because of the resulting changes in the definition of liabilities, and resulting impact on debt limits—a scenario private equity will not want to inherit. According to the new rule, the FASB stated that operating lease liabilities are operating liabilities and are not debt. Nevertheless, borrowers should contemplate negotiating debt covenants based on existing GAAP at the time of the debt agreement.
The upcoming FASB lease accounting rule is welcome news for private equity firms, but its aim of fostering uniformity across company financials will depend on compliance by potential target companies and portfolio companies. Because the rule is new, differing levels of interpretation are bound to ensue, so investors will want to make sure all lease agreements are accurately recorded in accordance with the new guidelines to avoid any valuation surprises.
The proper vetting of acquisition targets today will ensure a consistent comparison of company financials tomorrow–and greater likelihood portfolio companies are accurately valued for investor peace of mind.