The way you look at EBITDA (earnings before interest, taxes, depreciation and amortization) might be changing. New rules for accounting for leases have been proposed by the Financial Accounting Standards Board (FASB) that will, in essence, require almost all leases to be put on the books as capital leases. The operating lease as we know it may be a thing of the past, with a few limited exceptions. For many companies, this will require adjustments not only in their financial reporting but also in how they look at their financial covenants and acquisitions.
The effects of these proposed rules could change a company’s EBITDA and its debt-to-equity ratios, among other items. The EBITDA effect is a result of moving rent expense off the income statement and replacing it with depreciation and interest. The following chart* illustrates the effects this change could have on EBITDA:
As you can see from the column labeled “Proposed Rules,” EBITDA is higher, but there has not been any change in the economics or cash flow. When looking at an acquisition, it would be a mistake to blindly take EBITDA times a multiplier as a barometer to value a company or potential acquisition. The value obtained under the existing accounting rules would be lower than the value produced under the proposed rules in this example.
Once again, nothing has really changed with respect to the true economics; therefore, EBITDA or the multiplier will have to be normalized (adjusted) in order to achieve the correct value. This is true when comparing amounts pre-FASB change to post-FASB change. Adding the lease obligation to the books will also require a deduction of the lease debt from the enterprise value in order to adjust for the new accounting. In theory, the two calculations should result in basically the same number, but many times, they do not, due to the estimates used such as interest rates, residual values, asset lives, etc.
With respect to bank covenants, many are based on debt-to-equity ratios or EBITDA coverages. The new rules will affect both, and therefore the covenants will need to be addressed and reset with the lending institution prior to the implementation of the new rules.
The new rules can be very complicated and have many unforeseen consequences. Having a good understanding of the effects prior to the implementation of these rules will help you avoid pitfalls and mistakes.
*Assumptions include a seven-year lease ($14,280/year), value of the asset is $100,000, interest rate 8%, depreciation over five years and property reverts to lessor at end of lease.
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