How new lease accounting rules will affect private equity

After waiting 10 years for the Federal Accounting Standards Board (FASB) to complete its new lease accounting standard, private fund managers could be forgiven for not being stirred by news that the final version has at last been published. But its impact on the industry should not be overlooked.

The new standards require that companies recognize leases with terms longer than 12 months on their balance sheets, be they for real estate, airplanes, manufacturing equipment, etc.

Firms have long been able to exclude most of these, which may have made it difficult for investors to calculate the GP’s true financial obligations. The new rule aims to give prospective investors a more accurate picture of a company’s health.

For public companies, the new standard will be effective for fiscal years beginning after December 15 2018, while for private companies the effective date is 12 months later. (Early adoption is permitted.)

While those dates may seem a long way off, there’s plenty of work to be done before then. The first step? Gathering an inventory of all leases (which may be buried in service arrangements or tucked away in filing cabinets) and abstracting the key financial information. This process may take “considerable time and effort,” noted PwC in client brief about the standard.

At the management company level, chief financial officers will be responsible for this process, and for ensuring all accounting is compliant for leases on items like office space or private planes. At the portfolio company level, the standard will change how companies report to their private equity backers, and will have an impact on debt to equity ratios.

As a result of the balance sheet changes, the transition to the new standard may have an impact on debt covenants and the apportionment of income for state taxes as well.

In terms of valuation methodology, the update may also change how private equity firms look to value their companies, and will be an important consideration when thinking about comparability. For example, a firm using public market comps in 2019 will have to take into account that those companies likely already transitioned over to the new standard. The result is an extra layer of work on the valuation and due diligence functions.

And for global private equity firms the matter gets even more complex. Because although the International Accounting Standards Board and FASB launched the lease accounting project together back in 2006, their final versions differ. Leases classified as “operating leases” by the FASB will be accounted for differently under US accounting guidelines than under international reporting standards, and will have a different effect on income statements and cashflows. 

Similar to the recently converged revenue recognition standard (which goes into effect December 2017 for public companies and a year later for private companies), the impacts of the new lease accounting rules may seem a long way off, but the effects could mean a lot of extra work down the line for those unprepared. Putting out more immediate fires will be the natural inclination of today’s time-strapped CFO, but lease accounting also deserves your time and attention, sooner rather than later.