Lease Accounting Guidance
If you’re like most startups, you lease your assets (office space, vehicles, machinery, technology) as a strategic investment to keep costs low, especially during the earliest stages of any startup. There are new requirements that startups need to know, and consider implementing, if they want to remain GAAP compliant.
ASC 842 applies to “leases”, and you’ve probably got at least one. The most common is your office. Detailed guidance can be referenced in this handy 46 page PDF published by the Financial Accounting Standards Board. We have attempted to summarize the relevant points in our blog post but best advice, work with a good accountant/ financial partner who can help you determine if being compliant with ASC 842 makes sense for your startup. It’s about to get complicated, so let’s dig in!
ASC 842 – What is it?
This accounting rule requires GAAP compliant companies to record most of their operating leases on the balance sheet. For most startups, this means that instead of simply recognizing an office lease every month, they will capitalize the entire amount on their balance sheet at the beginning of the agreement and recognize a portion every month.
Why was ASC 842 Created?
We’ve all heard of the financial issues in the early 2000’s, when companies like Enron figured out how to cook their books in several creative ways, including doing some not so “transparent” things with long term leases. Traditionally, leases were just expensed as the monthly rent payment happened.
ASC 842 Introduces a Lessee Model that Brings Most Leases Onto the Balance Sheet.
The rational is that leases don’t go away; companies are signing contracts that require them to make all of the payments. As an investor, wouldn’t you want to know if you were investing in a company that had signed up for a 20-year lease that requires a $1 million early termination fee?
Example- if you sign an equipment lease contract for 5 years, with agreed upon payments amounts of $15,000 per month, then a lease liability of $900,000 ($15,000 * 12 months * 5 years) should be recorded in the Liabilities section of the balance sheet.
Is ASC 842 Applicable to Private and Closely Held Businesses?
A funded company is not required by law to follow ASC 842. That being said, most experienced VCs want to see GAAP financials. It makes valuations comparable, being acquired faster and easier, improves audit processes and reflects management’s approach to having a compliant financial framework. We recommend that our founders who are trying to create industry-defining companies strive to have best-in-class operations, including being as close to GAAP compliance as possible.
Impact of this Standard on Companies and their Financial Ratios
Practitioners have estimated that $2 trillion of lease liability (with corresponding recognition of leased assets) will be recorded to S&P 500 balance sheets alone as a result of the application of the new leasing guidance.
Key financial ratios, such as the debt equity ratio and other leverage ratios, are likely to get adversely affected with adoption of this standard, and in turn affect borrowing capacity and debt covenants of companies.
To illustrate this, below is an example of a balance sheet of a company, before and after the adoption of the standard.
To give an example of a ratio that would change as a result of this let’s look at Debt/Equity Ratio.
· This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding extent of security of the debt.
· A low debt equity ratio reflects more security.
· A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders.
· Before the adoption of ASC, the ratio is at 23%. After adopting it however it increases the operating liability by $6,000, which in effect increases the ratio by 10% to 33% Debt/Equity.
Debt Covenants
The new standard requires companies to present operating lease liabilities outside of traditional debt, which may provide relief to some. Nevertheless, it will be critical for all companies to determine the ASC’s potential effects on debt covenants, so discussions with lenders will likely be needed to understand possible implications and determine whether amendments may be required.
What are the Considerations for Valuation?
Changes in the accounting of leases should not generally impact a business valuation conclusion. However, because the treatment of operating leases can influence the calculation of cash flows, discount rates, and valuation multiples, appropriate consideration and adjustments to the calculations should be taken to ensure the valuation conclusion does not differ based on accounting treatment. While the financial and valuation analysis impacts are complex, Book+Street can help! We have professionals with the expertise to accurately adjust financial and valuation analysis for the new lease accounting standards.
Next Steps to Implement ASC 842
1) Do Not Wait Too Long – identify, document, review and record all lease arrangements.
2) Work with your Accountants and Financial Advisors to implement the standard right, right from the start!
Citations/Further Information
“ASC 842 Guide.” Cradle Accounting, https://www.cradleaccounting.com/asc-842-guide#initial-recognition.
“Important Considerations for Calculating ASC 842 Assets and Liabilities.” ASC 842 Valuation Considerations and Balance Sheet Impacts, 27 Oct. 2020, https://www.mossadams.com/articles/2020/10/calculation-considerations-for-asc-842.
“What Changes to the Lease Accounting Standards Means for Business Valuation.” Marcum LLP, 28 Apr. 2022, https://www.marcumllp.com/insights/what-changes-to-the-lease-accounting-standards-means-for-business-valuation.
“How to Calculate the Lease Liability and Right-of-Use (ROU) Asset for an Operating Lease under ASC 842.” Cradle Accounting, https://www.cradleaccounting.com/insights/how-to-calculate-the-lease-liability-and-right-of-use-asset-for-an-operating-lease-under-asc-842.
