ASC 842 Lease Accounting Improves Financial Ratios

ASC 842 lease accounting rules could allow analysts to cut a company’s operating lease liabilities in half.

Under old guidelines in ASC 840, capital leases—which provided a lessee rights similar to ownership—were treated like owned assets, and the company recorded capital lease assets and liabilities on its balance sheet. But operating leases—which did not meet the criteria for capital treatment—were subject to different accounting guidelines. ASC 840 didn’t require assets and liabilities associated with operating leases to be recorded on the balance sheet, but it did require operating lease expenses to be recorded on a straight-line basis on the P&L statement.

Analysts looking to compare the balance sheets of companies were at a loss. They could see on a balance sheet the liability of a company that financed an asset with debt but not the lease liability of a company that financed an asset with an operating lease. This difference in balance sheet treatment existed for many years even though the substance of the two transactions were similar. The company that financed the asset with debt used the asset and made payments over time. The company with an operating lease also used the asset and made payments over time.

Since there was no operating lease liability on the balance sheet, analysts used a formula to approximate the liability. They typically multiplied a company’s operating lease expenses by seven.

It turns out that the new lease accounting guidelines in ASC 842—which require companies to gross up the balance sheet with lease liabilities and right of use (ROU) assets for operating leases—may put companies in a better financial light.

In a December FASB meeting, board member Gary Buesser said, “Under 842, the median lease liability multiple, according to our XBRL team’s data analysis of 1,400 companies, is 3.5 times.”

This difference between the seven-times and 3.5-times lease expense multiples represents a significant decrease in the liabilities that analysts may assign to operating leases. If analysts use reported ASC 842 operating lease liabilities instead of a seven-times lease expense multiple to approximate those liabilities, their assessment of a company’s liabilities associated with operating leases could be cut in half. This could dramatically improve financial ratios that include liabilities.

How is it possible that by applying a new accounting standard companies can end up with a much lower lease liability than analysts have typically approximated? The answer to this question mainly lies with a few definitions and assumptions that companies must apply under ASC 842.

The lease liability is defined in ASC 842 as “a lessee’s obligation to make the lease payments arising from a lease, measured on a discounted basis.” In other words, lease liability is the net present value (NPV) of lease payments. NPV requires three inputs: a discount rate, the amount of payments, and the timing of those payments, also known as the lease term.

Assuming lease payments are fixed, the two variables that can change the NPV are the discount rate and the lease term.

The discount rate that most lessees need to apply under ASC 842 is the incremental borrowing rate. Mathematically, the higher the discount rate, the lower the NPV. So, if a lessee identifies a higher incremental borrowing rate, this will result in a lower lease liability balance.

The lease term under 842 includes periods covered by an option to extend the lease that the lessee is reasonably certain to exercise. So, if a lessee determines that the company isn’t likely to extend a lease, the lease liability will be lower.

The IBR and the lease term are determined by each individual company for each lease as companies calculate their ASC 842 operating lease liability balance. This tailored approach makes it possible for companies to calculate an operating lease liability balance that may be lower than previous analyst estimates.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Matt Waters is a CPA and Director of Lease Accounting for CoStar Manager.