How ASC 842 Lease Accounting Affects Key Performance Indicators
With the ASC 842 lease accounting standard, companies must report most leases as assets and liabilities on the balance sheet, shifting both operational and financial strategies. This change affects critical performance indicators, impacting how companies report financial health and manage tax implications. For companies navigating these requirements, understanding how leasing structures—such as finance leases and operating leases—affect different metrics is essential. In this post, we’ll explore the key performance indicators impacted by ASC 842, outline examples of how these changes might play out in real-world scenarios, and offer actionable steps for various roles within an organization.
Key Performance Indicators Affected by ASC 842
The ASC 842 standard requires companies to recognize Right-of-Use (ROU) assets and lease liabilities on the balance sheet, impacting many financial metrics. Let’s break down the performance indicators most affected and how different leasing structures, namely finance and operating leases, impact these measures.
Return on Assets (ROA)
ROA measures the efficiency of a company’s asset utilization by dividing net income by total assets.
Impact: ASC 842 requires both finance and operating leases to add ROU assets to the balance sheet, increasing total assets and potentially lowering ROA.
Example: A company with high-value, long-term leases for equipment sees a significant rise in assets under ASC 842, lowering ROA despite stable income. In this case, choosing shorter-term operating leases could minimize asset growth and keep ROA relatively stable.
Strategic Actions: CFOs should evaluate whether to lease or buy based on ROA goals. Companies focusing on high ROA may prefer operating leases or shorter lease terms to control asset inflation.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA is a profitability metric commonly used in debt covenants, calculated as operating income plus interest, taxes, depreciation, and amortization.
Impact: Under ASC 842, operating leases reduce EBITDA because lease payments are recorded as operating expenses, while finance leases generally do not.
Example: A retail chain using finance leases for store locations can keep lease costs outside of EBITDA, presenting stronger profitability for potential investors.
Strategic Actions: Companies looking to maintain a strong EBITDA may prefer finance leases to exclude lease expenses from operating costs, beneficial for companies with EBITDA-based debt covenants.
Debt-to-Equity Ratio
The debt-to-equity ratio measures financial leverage by comparing total liabilities to shareholder equity.
Impact: Lease liabilities are recorded as debt under ASC 842, impacting this ratio and potentially signaling higher leverage.
Example: An asset-heavy company adds lease liabilities under ASC 842, raising its debt-to-equity ratio and affecting its attractiveness to lenders.
Strategic Actions: CFOs might negotiate shorter lease terms to manage debt levels. Companies can communicate the impact of ASC 842 to stakeholders, clarifying that increased debt reflects transparency rather than additional risk.
Net Income and Earnings Per Share (EPS)
Net income is the company’s total profit, while EPS is calculated by dividing net income by outstanding shares.
Impact: ASC 842 impacts these measures differently for finance and operating leases. Finance leases may reduce net income early on due to front-loaded expenses, affecting EPS.
Example: A company with substantial finance leases sees lower EPS in the early years of adoption, affecting investor perception.
Strategic Actions: Financial analysts and investor relations teams should prepare to explain the short-term volatility in EPS due to ASC 842 and highlight long-term benefits, such as lower overall costs in later years.
Free Cash Flow (FCF)
FCF reflects the cash generated after capital expenditures, essential for financial health and investment analysis.
Impact: Finance lease payments split between principal and interest affect financing and operating cash flows, often improving FCF. Operating leases, however, count lease payments as operating outflows, reducing FCF.
Example: A technology firm with finance leases reports higher FCF, making it more attractive to investors focused on cash flow.
Strategic Actions: CFOs may leverage finance leases to enhance FCF and project a stronger cash position, essential for capital-intensive industries.
Navigating ASC 842: Actions and Mitigation Strategies by Role
For CFOs and Finance Teams
- Optimize Lease Structure: Carefully assess whether finance or operating leases align better with strategic goals, particularly around metrics like ROA, EBITDA, and FCF.
- Communicate with Stakeholders: Clearly explain the changes in financial statements, highlighting that increases in liabilities are a result of ASC 842 transparency rather than new debt.
For Accounting Teams
- Ensure Accurate Reporting: Maintain compliance with ASC 842 by consistently updating ROU assets and lease liabilities with any lease modifications.
- Prepare for Audit Scrutiny: Document all assumptions, particularly around discount rates and lease classifications, to streamline audits and meet regulatory requirements.
For Investor Relations Teams
- Manage Investor Expectations: Proactively address potential EPS and debt-to-equity ratio impacts with investors, clarifying that these changes stem from accounting adjustments rather than operational risks.
- Highlight Strategic Advantages: Emphasize long-term profitability and improved cash flow (in finance lease scenarios) to attract cash flow-focused investors.
For Tax Advisors
- Analyze Tax Implications: Review the tax treatment of lease payments under finance and operating leases, especially since tax reporting may differ from financial reporting.
- Advise on Lease Terms: Guide lease negotiations with tax benefits in mind, including optimizing lease terms that align with tax and accounting objectives.
In Summary
ASC 842 has introduced significant changes to lease accounting, impacting a range of performance indicators. By understanding how finance and operating leases affect key metrics, companies can strategically structure leases to balance financial transparency with profitability goals. For CFOs, accountants, investor relations teams, and tax advisors, this requires proactive planning, clear communication, and ongoing adjustments to maintain alignment with organizational objectives. Navigating ASC 842 effectively not only enhances compliance but also strengthens the company’s overall financial resilience and strategic positioning in the market.
Tour of iLeasePro
Schedule a Demo
Check Out Knowledge Base
