During 2016, The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016 – 02, Leases. The purpose of the update is to address transparency and improve reporting of obligations for entities involved in leasing activities. The impact of the new standard on lessors will be minimal, primarily affecting income statement reporting. However, for lessees, the new standard will impact both the balance sheet and the income statement. For leasing obligations that are not considered “short-term leases” (12 months or less), lessees will now need to record a “right of use” asset along with a corresponding “lease liability” that is to be amortized over the life of the leasing agreement. Adding this lease liability to the balance sheet could create a violation of certain loan covenants, even though this new liability will not be considered debt in the eyes of the FASB.
What will change?
The new standard will create two types of leases – finance and operating. Leases that are currently considered capital leases will now be called finance leases and will retain substantially all of their current reporting requirements, which includes certain Balance Sheet reporting. Operating leases, on the other hand, are obligations that are not currently reflected on the Balance Sheet and will be required to be included when the new standard takes effect. So, how will this work under the new standard? For starters, in addition to the requirement to report operating leases separately from capital leases, lease renewal options that are reasonably expected to be exercised in the future will need to be factored in.
How will that work?
For example, a contractor enters into an agreement to lease a new main office for ten years, with the option to renew for an additional five years. If it is reasonable to assume that the contractor is not going anywhere when the original lease is up and will exercise the right to renew the 5 year option, the lease would be recorded on the Balance Sheet at the present value of the lease obligation and amortized over the intended fifteen years. This is a dramatic change from the original expensing over the ten year lease term that would have been recorded off the balance sheet under the previous standard.
What does this have to do with my loans?
The new FASB leasing standard may have no impact on your loans whatsoever, or it may put you in violation of your loan covenant. Let’s assume your loan requires a debt to equity ratio of 1.25:1 or less. While the FASB may not consider the treatment of your operating leases as debt obligations, your bank may see things differently. For example, a borrower who under current accounting rules has a balance sheet consisting of $500k in assets and $250k in liabilities would have a net worth of $250k. In this case, the debt to equity ratio is 1:1, which is in compliance with the loan agreement. Now let’s take that same borrower and record an additional $250k representing the present value of all future operating leases on the balance sheet. This entry adds assets of $250k and corresponding liabilities of $250k, so it’s a wash – right? Wrong. Assets now become $750k and liabilities are now $500k, while net worth is still $250k. Under the new guidance the borrower now has a debt to equity ratio of 2:1, and is in direct violation of their loan covenant.
In addition to the impact on your debt to equity ratio, consider also that under the new accounting guidance, interest expense will be broken out as a separate component of the amortization of the lease liability. This would increase the interest expense associated with the borrower’s operating leases and in turn would impact any covenants that are based on interest expense restrictions.
When does all this take place?
For public companies, the new standard will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. For all other organizations, it will be effective for fiscal years beginning after December 15, 2019 and interim periods beginning after December 15, 2020. Early adoption is permitted for all organizations. One thing to note is that a comparative presentation will need to be disclosed in the initial financial statements prepared after the standard takes effect. Therefore, it may benefit you to begin discussions with your CPA to determine what information will need to be gathered in preparation for the new disclosures.
What can I do to address the impact on my loan covenants now?
There are several things that you can do now to ensure that your loan covenants will not be in violation due to your revised financial statement under the new FASB. First, it would be a good idea to review the leases your company has in effect currently and to determine how they will be classified under the new standard. Run the numbers and get an idea of what your financial information would look like if the standard were implemented today, taking into account the financial impact of all leases that are up for renewal, and any potential new leases on the horizon. Estimate the impact these leases will have on your loan agreements and consider how this will affect any lease vs. buy decisions. Finally, communicate with your lenders. Talk with them about what the future impact could be, and any possible changes that may need to be made to your loan agreements. The most important thing is to be proactive. Adaptation to this change in accounting will proceed smoothly with preparation. MKS&H is here to help you through it.
Article Contributed by Jeff Rubin
About MKS&H: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.