How ASC 842 (the lease reporting standard) Can Impact the Sale of Your Business

What is ASC 842?

The Accounting Standards Update (ASU) 2016-02, commonly known as ASC 842, requires that all companies large and small that issue GAAP-based financials account for leases on their financial statements.  It was issued by the Financial Accounting Standards Board (FASB) in February 2016 and was effective January 1, 2022. ASC 842 significantly changes how companies account for leases on their financial statements and may impact the sale of your small business.

ASC 842 applies to both private and public companies that enter into lease agreements. The standard applies to all leases, including operating leases and finance leases, with certain exceptions such as short-term leases (leases with a term of 12 months or less) and leases of low-value assets (such as office furniture and equipment).

For companies with complex lease agreements, including operating leases for real estate, equipment, and other assets. The implementation of ASC 842 affects how these leases are reported on financial statements and can have a significant impact on a company’s financial metrics.

Impact on Due Diligence

One of the primary impacts of ASC 842 within a sale transaction is the increased complexity of due diligence. Under ASC 842, companies must report all leases on their balance sheet, including lease liabilities and right-of-use assets. This requires a detailed analysis of all lease agreements, including identification of lease terms and conditions, calculation of lease liabilities and right-of-use assets, and determination of lease classification. This diligence will likely be a focus of a buyer prospect and their advisors.

The lease assets and lease liabilities will not always be equal. Under ASC 842, the initial recognition of the lease liability is equal to the present value of the lease payments over the lease term, discounted using the interest rate implicit in the lease or the lessee’s incremental borrowing rate.  The lease asset under ASC 842, is the conveyed right to control the use of the identified property.  It is initially measured as the sum of the lease liability, any lease payments made at or before the commencement date, and any initial direct costs incurred by the lessee, such as leasehold improvements. Therefore, if the lessee makes any lease payments before the commencement date or incurs any initial direct costs, the lease asset will be greater than the lease liability.

Additionally, the lease liability may change over time due to various factors, such as changes in lease payments, modifications to the lease agreement, or reassessments of the lease term or discount rate. This could cause the lease asset and lease liability to differ at any given point in time.

This increased complexity can make due diligence more time-consuming and costly, especially for companies with a large number of lease agreements. As a result, buyers and sellers may need to engage additional accounting resources or expertise to ensure compliance with ASC 842 and accurately report lease obligations.

Impact on Valuation

Another impact of ASC 842 on a business sale transaction is the potential effect on valuation. ASC 842 brings previously off-balance sheet operating leases onto a company’s balance sheet.  By reporting all leases on the balance sheet, ASC 842 can impact a company’s financial metrics, such as debt-to-equity ratio and in some cases adjusted earnings metrics, like EBITDA.

Adjusted earnings could change based on the classification of a lease as an operating or finance lease.  Under an operating lease the company typically reports the entire expense as lease expense under SG&A.  Expense under a finance or capital lease consists of amortization and interest.  While reported income is relatively unaffected by this difference in treatment, the expense classification impacts adjusted earnings for valuation purposes because amortization and interest expense are typically “add-backs” and lease expense is not.  An example of how the classification of a lease can affect EBITDA can be found in this article: https://blog.netgain.tech/exploring-operating-vs.-finance-lease-journal-entries-and-amortization-calculations.

A lease classified as a financing rather than an operating lease will likely affect a company’s EBITDA, resulting in a change of value.  However, the difference in value would be offset to some extent in a business sale transaction where the liability incurred under the financing lease is considered a “debt-like item” and is paid off by the seller.

Ultimately, analysis will need to be completed on a case-by-case basis to understand the magnitude and direction of impact from ASC 842 on a company’s business value.

Impact on Deal Structure

ASC 842 may also impact the structure of your deal. For example, buyers may choose to structure the transaction as an asset purchase rather than a stock purchase to avoid assuming the seller’s lease liabilities. Alternatively, buyers may negotiate adjustments to the purchase price based on the impact of ASC 842 on the target company’s financial statements.

Conclusion

In conclusion, ASC 842 may have significant implications for the sale of your small business. The increased complexity of due diligence, potential effect on valuation, and impact on deal structure require careful consideration by both buyers and sellers. Companies with complex finance and capital leases should work with experienced accounting professionals to ensure compliance with ASC 842 and accurately report lease obligations. By doing so, they can help facilitate successful sale transactions and minimize the risk of unexpected financial impacts.

Adam Wiskind is not an accountant, but he can certainly refer you to a good one.  If you’d like to have a confidential, no commitment discussion on your exit plans or the sale of your business, please contact Adam Wiskind, Senior M&A Advisor at (707) 781-8744 or awiskind@exitstrategiesgroup.com.