New Lease Accounting Rules Impact on Valuation
Lately, there have been discussions online about the impact of ASC 840 and 842 (rules on accounting for leases) on valuations of businesses. ASC 840 was the original lease accounting under generally accepted accounting principles (GAAP). It required the “booking” of capital leases on the income statement and balance sheet. ASC 842 replaces ASC 840. The biggest change from ASC 840 to ASC 842 is the requirement to record an asset and liability associated with all leases greater than 12 months in term. Previously, only capital leases were recorded on the balance sheet as an asset and liability. Now, operating leases will also be recorded on the balance sheet as well as the footnotes.1
What will be the impact on valuations of closely held businesses? One of the main potential issues is the fact that financial statements post-implementation of ASC 8422 might not be comparable to financial statements prior to that date. But it is more complex than that. Steve Campana, of Honkamp Krueger & Co., provided a short but good analysis of the issue:
- Many assignments of small and medium-size entities start with financial statements that use as their root source either: (1) company tax returns; or (2) financial statements on the cash or tax basis of accounting. More recently, we have many clients that have adopted the Financial Reporting Framework for Small and Medium Size Industries (FRF/SMEs) published by the AICPA. I believe this framework allows for leases to continue to be reported using FASB 13 framework regarding operating versus capital leases.
- I am not sure whether I see a need to convert these financial statements to the new lease standard to conduct an engagement. If the new lease standard is believed to represent the economic substance of these leases, then why have we not made this economic adjustment in the past?
- If we do not believe the new standard reflects the economic substance of the leases, should we convert the financial statements back to their pre-ASC 842 presentation? A similar comparison might be the case where we may have adjusted LIFO inventories to FIFO in conducting our work.
One of the reasons for the implementation of ASC 842 is to comport with the treatment in international circles and to reflect the economic effect of both capital and operating leases on the income statement and balance sheet. But is that really necessary or even material to many of the small businesses that we commonly value? Expect to see more discussion in the future as the implementation of ASC 842 matures and ages.
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1 Chandu Chilakapati, managing director, Alvarez & Marsal Holdings LLC, 2022.