ASC 842 leases, explained simply
Before ASC 842 a company could lease a building for ten years and show no liability. Now most leases are recognized, which makes classification important in deals: operating lease cost remains in operating expenses and so reduces EBITDA, while finance lease cost is split into amortization and interest and does not.
Treating an operating lease as debt as well would deduct it twice, once through lower EBITDA and again through net debt.
Operating and finance leases
ComparisonConsistent classification avoids double-counting between EBITDA and net debt.
Worked example
- Factory lease: $250,000 a year for ten years, an operating lease. It stays in operating costs, reduces EBITDA and is not treated as debt.
- Equipment lease: a $0.6 million finance lease. It is excluded from EBITDA and included in net debt.
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Timing
Private companies following US GAAP adopted ASC 842 for fiscal years beginning after 15 December 2021. Earlier years in a diligence period may follow the previous rules, so diligence compares every year on the same basis.
Why it matters in a deal
Lease classification affects both EBITDA and net debt. Consistent treatment avoids double counting and unwarranted price adjustments.
Red flags
- Leases not recorded at all
- Classification changed shortly before the sale to improve EBITDA
- Related-party leases with no written agreement