The article “The Potential Impact of Lease Accounting on Equity Valuation” (Matthew A. Stallings, November 2017, http://bit.ly/2ktNGIR) provides an example of the effect of the leasing standard’s guidance [ASU 2016-02, Leases (Topic 842)] on equity valuation. The example illustrates an issue that may arise if analysts fail to recognize that “lease expense” reported under the single classification treatment implicitly includes both an operating expense and an interest (financial) expense. Unaddressed, this may result in an error in the calculation of equity value.
Of course, accountants know that the underlying value of an asset does not change with the choice of an accounting standard. For example, customers do not pay a different amount depending upon whether the inventory is accounted for using last-in-first-out or first-in-first-out. Thus, if accountants find a different value for an asset in their analysis when a different set of accounting methods is used, they must identify and correct the mistake that has been made.
The article concludes that “CPAs will want to take any appropriate adjustments deemed necessary regarding dual-classification versus single-classification treatment of leases under U.S. GAAP or IFRS, and the implications for equity valuation into consideration when estimating cash flows, cost of capital, and equity.” In this letter, we will describe these appropriate adjustments and show that the value of equity under the new standard is the same as before the update.
ASU 2016-02 suggests that the obligation under the lease ($7,560 in the article) would be reported as a financial obligation, but the cost of the obligation is not shown as interest expense. Under the new accounting standard, the single-classification treatment would record the full cost of the lease being reported as “lease expense,” despite a portion being the direct result of a financial borrowing.
To perform an accurate analysis and valuation, one must infer and adjust for the cost of the debt; that is, infer the interest expense. Failing to do so may—as seen in the example in the article—result in a financial obligation on which there appears to be no interest expense; all expenses are assumed to be operating in nature. If one recognizes that the borrowing would result in $378 in interest expense ($7,560 × 5%) and remove this from the $1,020 lease expense, one is left with a $642 “lease expense, net of implied interest.” Performing the analysis and valuation after this adjustment results in a GAAP adjusted discounted cash flow valuation of $5,899.56, exactly mirroring the IFRS adjusted. Details are provided in the Exhibit.
Adjustment for Implied Interest Expense
In summary, given that accounting method choices do not change underlying value, the unintended consequences mentioned in the November 2017 article should cause one to pause and think. The take-away is that, in analysis and valuation, accountants must identify the financial expense related to the financial obligation that has been added to the book by the new leasing standard. By making the necessary adjustment for the implied interest expense, one will continue to arrive at the equity value, which would have been estimated from accounting data provided before ASU 2016-02.