The New Lease Accounting Standard and the Impact on Loan Covenants

In February 2016, the Financial Accounting Standards Board (FASB) issued the new lease accounting standard, Accounting Standards Update (ASU) 2016-02, Leases. The intent of the new standard is to increase transparency and comparability among organizations that engage in leasing, as well as improve financial reporting and disclosures of key information regarding leasing arrangements.

Current lease accounting has been criticized for failing to meet the needs of financial statement users because it has not always provided a faithful representation of leasing transactions. There is a lack of recognition of assets and liabilities arising from operating leases on the balance sheet. The main objective of the new standard is that entities should recognize a right-of-use asset and a corresponding liability to make lease payments for all leasing arrangements with lease terms in excess of twelve months.

While the changes under the new lease accounting standard add complexity to the accounting for leasing transactions, there could also be a significant impact to an entity’s lending agreements. As you evaluate how the new lease accounting may affect loan agreements and compliance with debt covenants, consider these five key items:

  1. Leverage Ratios – As additional liabilities are reflected in the balance sheet for operating lease obligations, a company’s leverage ratio may be negatively impacted. Financial covenant requirements based on leverage ratios that include total liabilities compared to total equity may need to be restated in loan agreements, or clarified to exclude operating lease liabilities.
  2. Current Ratios – Liabilities from lease obligations include both current and long-term classifications. Right-of-use assets under leasing arrangements are classified as long-term assets. As a result, current ratio calculations comparing current assets to current liabilities may decrease under the new lease accounting guidance. This may affect certain financial covenants based on minimum current ratio requirements.
  3. Definition of Debt – Operating lease obligations may be considered debt, similar to finance lease obligations, as defined in certain loan agreements. Some loan agreements restrict the borrower from incurring additional debt. In addition, certain financial covenants may have ratios based on debt service and it may not be clear if lease liabilities are included. As a result, the definition of debt may need to be clarified in loan agreements to exclude liabilities resulting from operating lease obligations.
  4. Lease / Rent Payments – Certain loan agreements may include financial covenants that include rent payments as a component of a fixed charge ratio requirement. This may include lease payments under finance leases and operating leases, including related party amounts. Total rent payments may need clarification under the new lease accounting guidance, and certain financial covenants may need to be revised.
  5. EBITDA – It is common to have financial covenants in a loan agreement requiring a minimum EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) or a fixed charge coverage ratio based on EBITDA and debt service. Under the new lease accounting standard, there should be no change to EBITDA since the classification criteria for distinguishing between finance leases and operating leases are substantially similar to the existing guidance.

The new lease accounting standard became effective for public entities on January 1, 2019. For private companies, the new lease accounting guidance currently has an effective date of January 1, 2020. However, the FASB recently proposed an accounting standard update that would defer the effective date of the new lease accounting standard for one additional year to January 1, 2021. FASB issued this proposal as a result of feedback received from key stakeholders and implementation challenges encountered by private companies.

As private companies embark on the implementation process of the new lease accounting standard, it is critical to evaluate the impact it may have on lending agreements.

Debt covenants and certain terms in loan agreements may require restatement. Now is the time to communicate with your business advisors, accounting firm, and lenders to discuss anticipated changes to financial statements and debt covenant requirements well in advance of the implementation date, even if private companies are granted a year of relief.

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