PPP Loans: Accounting Treatment vs. Valuation Treatment
The U.S. government provided unprecedented relief to millions of small businesses by providing significant federal loans, after the onset of the COVID-19 pandemic (the “Pandemic”). After meeting strict eligibility requirements, many of these loans are expected to be forgiven. However, as the December 31, 2020 reporting period is looming, the high majority of these companies have not been informed that the government loans in fact were forgiven. The balance sheets of these companies, therefore, continue to reflect these significant loans and are of a concern should financial decisions need to be made for the Company, where the users are relying on the December 31 financial statements. This article reviews the background and accounting treatment of these federal loans, as well as how valuation firms are likely to treat these loans for valuation purposes.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (H.R. 748), enacted in the early spring of 2020, appropriated an estimated $2.2 trillion to fight the Pandemic, provide relief for workers and their families, and stimulate the US economy. $349 billion of the relief funding was earmarked for the Payment Protection Program (PPP) loan program administered by the Small Business Administration (SBA). Businesses large and small quickly applied for PPP loans, and Congress approved an additional $310 billion a month later.
- The CARES Act included financing options for small privately held companies, including PPP loans, to support operations during the COVID-19 pandemic and the accompanying economic shut down.
- Entities had to meet certain eligibility requirements to receive PPP loans and maintain specified levels of payroll and employment to have the loans forgiven. The eligibility conditions are subject to audit by the federal government, but entities that borrow less than $2 million are deemed to have met the initial eligibility requirements.
- The accounting for PPP proceeds, as either debt or government grants, may depend on whether an entity expects to meet the eligibility and loan forgiveness criteria.
The PPP Loan Primer
After the onset of the pandemic, millions of eligible small businesses applied for and received loans. The loans have a 1% fixed interest rate and are due in two years. The expectation is that companies will utilize the PPP loans for their intended purpose (by following strict SBA guidelines) and that the loans will be eligible for forgiveness (in full or in part, including any accrued interest) under certain conditions. For loans (or parts of loans) that are forgiven, the lender receives the forgiven amounts from the U.S. government.
PPP Loan Requirements
- In applying for a PPP loan, businesses were required to certify that they were suffering from economic uncertainty related to the pandemic.
- As noted in the SBA Frequently Asked Questions (FAQs), it was the responsibility of the borrower to certify that it was eligible to receive a PPP loan (i.e., no independent lender eligibility certification was required).
- The SBA indicated that the necessity certification was subject to audit but provided a safe harbor for any borrower (together with any affiliates) that received a PPP loan of less than $2 million so long as it made the certification in good faith.
PPP Loan Forgiveness
- Many companies are now applying for loan forgiveness. The loan forgiveness requirements include retaining employees and payroll at certain specified levels during either an 8- or 24-week period.1
- Borrowers seek loan forgiveness by submitting a loan forgiveness application and relevant documentation supporting eligible expenses to their lender.
- According to the FAQs, all loans that exceed $2 million are subject to review by the SBA for compliance with program requirements, including eligibility.
PPP Loan – Accounting Treatment
According to discussions with the Assurance group at Marcum, as the legal form of a PPP loan is debt, it will always be appropriate for an entity that receives such a loan to account for it as debt under Accounting Standards Codification (ASC) 470, regardless of whether the entity expects the loan to be forgiven. However, an entity that expects to meet the PPP’s eligibility and loan forgiveness criteria may elect to account for the proceeds similarly to a government grant. An entity that does not expect to meet the PPP eligibility and loan forgiveness criteria must account for the loan proceeds as debt. Both approaches are discussed below.
Treatment as Debt
Under ASC 470, an entity recognizes a liability for the full amount of PPP proceeds received and accrued interest over the two-year term of the loan. The entity does not impute additional interest at a market rate because the guidance on imputing interest in ASC 835-30 excludes transactions where interest rates are prescribed by a government agency (e.g., government-guaranteed obligations).
If any amount of the PPP loan is ultimately forgiven (i.e., the entity is legally released from being the loan’s primary obligor in accordance with ASC 405-20), then the following treatment applies:
|Balance Sheet||Income Statement||Statement of Cash Flows|
|Debt is removed from the balance sheet, as of the date that the lender provides notification that the debt is forgiven.||Income is recognized due to the extinguishment of the liability as a non-cash gain on loan extinguishment in the “Other Income” section of the income statement in the year the loan is extinguished.||
Treatment as Government Grant2
If an entity expects to comply with the PPP eligibility and loan forgiveness criteria, and it reasonably expects to receive forgiveness, it may account for the forgivable PPP loan as a government grant that is earned through the entity’s compliance with the loan forgiveness criteria. If the entity does not expect to comply with the PPP eligibility and loan forgiveness criteria, the proceeds should be accounted for as debt, as discussed above.
There is no U.S. GAAP guidance available to for-profit business entities that receive government grants that are not in the form of a tax credit or revenue from a contract with a customer. As such, business entities need to determine the appropriate accounting treatment by analogy to other guidance.3 However, an entity that accounts for PPP proceeds as a government grant will need to continually reassess its ability to meet the forgiveness conditions, and it may have to reverse the income treatment if it can no longer support a conclusion that it expects to meet the conditions. A not-for-profit entity that receives a government grant should apply ASC 958-605.
PPP Loan – Valuation Viewpoint for Appraisal Purposes
As appraisers, we look at the PPP loan with a slightly different lens than accountants, whose work results in determining the book value of a company under GAAP. The standard followed in developing opinions of value for a myriad of purposes (tax, ESOP, certain litigation, etc.) is the standard of Fair Market Value. A refresher on the definition of Fair Market Value is as follows:
The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state that, in addition, the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and the market for such property.4
In following the Fair Market Value standard, it is customary and ordinary to consider appraisal adjustments to either the business entity’s (i) balance sheet or (ii) income statement that would be considered reasonable by a hypothetical buyer. Adjustments to the balance sheet often remove nonoperating assets or liabilities, while adjustments to the income statements typically remove nonrecurring or nonoperating items or bring expenses to market levels.
In the case of a PPP loan, appraisers should request the following in order to review the appropriateness of making an adjustment (i.e., to remove the PPP loan as debt in determining the equity value of the business):
- The PPP loan amount;
- The status and timing of the application for forgiveness of the PPP loan;
- Management’s support for the expenses in the forgiveness application demonstrating satisfaction of the PPP loan forgiveness criteria;5
- Any and all documentation the company has regarding support for forgiveness of the PPP loan.
Based on an assessment of the above, the appraiser then uses professional judgment to determine if it is reasonable to adjust the PPP loan from the company’s balance sheet, considering the likelihood the loan will be forgiven and status of the documentation as of the valuation date. Appraisers use the “more likely than not” threshold to make such determination. If the business’s management deems it is highly probable that 100% of the PPP loan will be forgiven, it is then in the purview of the appraiser to determine if it is appropriate to remove 100% of the PPP loan from the balance sheet, as of the valuation date. Alternatively, the documentation may show that only a portion of the PPP loan may be forgiven or that there is no support for the forgiveness of the PPP loan. In those cases, the appraiser may adjust out only a portion of the loan or none of the loan balance.
It is also under the purview of the appraiser to determine if it is appropriate to remove 100%, a portion thereof, or none of the PPP loan from the business’ balance sheet as an adjusting entry, to determine the fair market value of the equity of the company as of the valuation date. In removing the portion of the PPP loan expected to be forgiven, the appraiser does not then consider this amount to be debt, and therefore, does not subtract it from the concluded value of the invested capital to determine the value of equity of the company.
An additional adjustment may be considered as an offset to the removal of the PPP loan. According to IRS Notice 2020-32, the expenses to qualify as eligible expenses for the PPP loan, and that are ultimately forgiven, are not deductible for federal income tax purposes. Further, the IRS clarified its position in Rev. Rul. 2020-27 that expenses are nondeductible in the year they are paid or incurred (i.e., 2020) if there is a reasonable expectation of forgiveness,6 regardless of whether the borrower files a forgiveness application in 2020 or 2021. Thus, the appraiser should consider whether or not there is an offsetting entry to recognize the additional associated tax liability for the forgiveness of the PPP loan that may not have been considered elsewhere in the valuation opinion.
Further, the appraiser should consider that the impact of the PPP loan on both the cash flow statement and income statement is generally nonrecurring in nature. If the PPP loan is ultimately forgiven, the GAAP income statement will show a non-cash gain on loan extinguishment. This item must be adjusted out of the income statement when determining normalized levels of income.
The accounting treatment for the PPP loan could be considered a more conservative approach as compared to the treatment for valuation purposes. PPP loans are treated as debt even if considered likely to be forgiven under ASC 470 because a PPP loan is a legally enforceable debt instrument. It is reasonable for appraisers to take a different viewpoint and consider the likelihood of debt forgiveness. Appraisals are forward looking, and it is the job of a business appraiser to consider whether it is more likely than not that the PPP loan will be forgiven in the future. If the facts and evidence show that all or a portion is expected to be forgiven, that expectation is reflected in the valuation.
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