ASC 842, Leases, Expands Due Diligence Process in Business Acquisitions
By Michael French, CPA, ABV, CFE, Managing Director
The new lease accounting standard that took effect at the beginning of this year for private companies, ASC 842, Leases, effectively expands the due diligence process for buyers in the process of making acquisitions. Buyers making acquisitions this year are advised to ask early in the process if the acquiree has yet applied ASC 842 to its lease accounting. If the answer is no, and the buyer’s objective is to arrive at GAAP financials, then additional work may be required to evaluate the acquiree’s leases under ASC 842. The good news is if the acquiree has already applied ASC 842 on its books, the buyer can use the lease classification in place of the acquisition without adjustment unless a lease is modified as part of the acquisition.
The lesson here for sellers who want to move their transactions along as fast as possible is to get your leases shifted to the balance sheet under the ASC 842 accounting rules now. Because the new standard requires shifting lease obligations to the balance sheet, buyers need to evaluate the inventory of leases of a potential acquiree and assess the impact it will have on the combined entity when the transaction is complete.
Moreover, if the buyer assumes any leases that the acquiree holds, then the transaction must be evaluated for treatment under ASC 805, Business Combinations, as well as ASC 842, Leases, both of which contain guidance for lease accounting.
Impact on Financial Ratios
Shifting lease obligations to the balance sheet does impact the financial ratios that bankers typically rely on to determine financing. Consequently, buyers must be aware that, as of this year, lease obligations are one more factor they must evaluate when considering an acquisition.
Essentially, ASC 842 has elevated the importance of leases in the acquisition process. Previously, leases simply represented another monthly or annual expense for a company and were noted in the financial statement notes. Now, leases must be stated on the balance sheet as a liability, with the value of the “right of use” stated as the corresponding asset. For sellers, assembling an inventory of leases may be an important factor in moving a transaction along quickly. The inventory of leases provides information to help buyers evaluate interest rates, cost of capital and net present value of lease obligations, among other factors. If you are looking to sell your business this year, accelerating the process of shifting lease obligations to the balance sheet before a buyer becomes involved can help move the transaction forward.
Lease accounting has become more complex as a result of ASC 842, impacting buyers and sellers alike and adding to the due diligence process.
For more information about the ASC 842 treatment of leases in your business transaction, contact your PKF Advisory team member or:
Michael French, CPA, ABV, CFE