How will the new lease accounting standard impact loan covenants?

A version of this article previously appeared in Equipment Leasing & Finance magazine.

Although most companies are focused on the impact new lease accounting guidelines will have on their financial statements, the guidelines also impact other external reporting, functional, and operational areas — including loan covenants.

Issued by the Financial Accounting Standards Board (FASB) as Accounting Standards Codification (ASC) Topic 842, Leases, the new guidance requires lessees to recognize assets and liabilities for substantially all leases. In particular, operating leases, which are off balance sheet today, are now recorded as an asset and liability in most cases. Though the FASB stated that liabilities from operating leases generally won’t meet the definition of debt under U.S. generally accepted accounting principles (GAAP), a question remains: How will lenders perceive those liabilities? And if lenders view the liabilities capitalized onto lessee balance sheets from operating leases as debt, will this cause companies to violate their loan covenants?

To summarize what’s changed: Under current accounting standards, leases that don’t meet the criteria for classification as a capital lease are classified as an operating lease. Operating leases don’t require lessees to record a liability or an asset on their balance sheet. In contrast, under ASC Topic 842, the present value of the lease payments on all leases — including operating leases — must be capitalized onto the lessee’s balance sheet as an asset and a liability. An exception for short-term leases, generally meaning those with a term of 12 months or less.

Impact on company ratios

Many companies have debt arrangements and credit agreements associated with borrowing or credit facilities. Often these agreements contain loan covenants that, if violated, trigger a default by the borrower. Ratios typically associated with loan covenants include:

• Basic fixed-charge coverage
• Current ratio
• Debt service coverage
• Debt to net worth
• Funded debt to EBITDA (earnings before interest, taxes, depreciation, and amortization)

The FASB acknowledged concern that the additional lease liabilities recognized upon adopting Topic 842 would cause some entities to violate debt covenants or affect access to credit. But because ASC Topic 842 characterizes operating lease liabilities as operating liabilities rather than debt, those amounts shouldn’t affect certain financial ratios often used in debt covenants.

In its basis for conclusions, the FASB noted that the effect of Topic 842 on entities’ covenants in existing debt or loan agreements is unlikely to be significant because:

• A significant portion of lease agreements contain “frozen GAAP” or “semifrozen GAAP” clauses. Accordingly, a change in a lessee’s financial ratios that results solely from a GAAP accounting change either doesn’t result in a debt covenant default or simply requires both parties to renegotiate in good faith.
• Bank outreach reveals an ongoing commitment to customers. Banks the FASB contacted stated they’re unlikely to dissolve a good customer relationship by calling a loan, even if an agreement doesn’t have a frozen GAAP or semifrozen GAAP provision.
• Operating lease liabilities are operating obligations rather than debt. Based on outreach, this decision by the FASB on disclosure as operating liabilities may substantially alleviate issues for some smaller entities with certain debt covenants.
• There’s still time before the guidelines must be adopted. The average life of most commercial and industrial loans — based on data obtained by FASB staff — means that many loans will be renegotiated before the effective date for ASC Topic 842 (especially private companies).

Further, third parties (such as credit rating agencies and lenders) often rely on lease-related footnote disclosures to determine future contractual obligations or compliance with loan covenants. Rating agencies and financial analysts already estimate operating lease liabilities, and they generally include this amount in the calculation of debt or financial liabilities for rating purposes.

Presentation of operating and finance leases

Under ASC Topic 842, liabilities capitalized from operating leases are to be shown separately from those of finance leases, either on the face of the balance sheet or in the notes to the financial statements. ASC Topic 842 also requires that lease liabilities be shown separately from other assets and liabilities either on the face of the balance sheet or in the notes to the financial statements.

Similar to today’s standard, ASC Topic 842 also requires lessees to disclose a maturity analysis of their lease obligations. Finance lease liabilities and operating lease liabilities (again, shown separately) should show the undiscounted cash flows on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. Lessees must also disclose a reconciliation of the undiscounted cash flows to the finance lease liabilities and operating lease liabilities recognized in the statement of financial position.

Finance lease liabilities also must not be presented in the same line item as operating lease liabilities. The FASB indicated that presenting the assets and liabilities that result from these two different types of transactions in the same line item in the statement of financial position would be misleading because it would convey an economic similarity that (in the FASB’s view) doesn’t exist.

Work ahead

Going forward, a company’s financial statement presentation and disclosures for leases will be critical for its financial statement users to discern current and future lease obligations for purposes of analyzing compliance with loan covenants. Given the ubiquitous nature of leasing, both the preparers and users of a company’s financial statements need to consider how the new requirements under ASC Topic 842 will impact financial reporting. Companies should consider taking steps today to inventory and understand the magnitude of the potential lease liabilities, enabling them to be fully informed of the financial implications.

Lessees should begin the discussions with their creditors or lenders now to understand how their financial information is used and what impact the new standard will have. For their part, lessors — especially financial institutions — should inform and train loan and credit officers about the impact of the new requirements, including this loan covenant issue, so they’re prepared to deal with clients or if technical defaults occur. Starting the discussion now will help both parties avoid unwanted surprises or disruptions in their credit facilities when the new rules are fully adopted.