The Clock is Ticking to Implement: Lease Standard Impact on Balance Sheet and Banking Covenants

By Scott Donnelly, on November 18th, 2021

As a private company, you may be wondering why you should start the implementation process of the new lease standard (ASC 842) now when it isn’t effective until reporting periods beginning after December 15, 2021. The answer is simple: the new ASU will require nearly every lease to be recorded on the balance sheet as a right-of-use (ROU) asset along with a lease liability recorded at present value on January 1, 2022. Under the current lease standard (ASC 840), operating leases are not recorded on the balance sheet. This will result in a balance sheet effect for nearly every company with an operating lease. This has the potential to significantly impact covenants on banking agreements, borrowing capacity, and third-party users of the financial statements.

Since this standard applies to all leases (from photocopiers to equipment to office rentals), it will have an immediate impact by increasing the assets and liabilities of virtually all companies. As a result, this may put your company in violation of loan covenants or limit borrowing capacity because most current banking agreements do not contemplate the new lease standard. These are some of the most common ratios and covenants utilized in banking arrangements, and the potential impact from implementing the new lease standard:

  • Debt Service Coverage Ratio (DSCR) – The DSCR will decrease if the total debt service of the company now includes the new lease obligations.
  • Current Ratio – The ROU asset will be recorded as a non-current asset and the recording of the lease liability will result in a portion being recorded as a current liability. This will reduce the current ratio by increasing current liabilities with no corresponding change to current assets.
  • Debt to equity ratio – If the ratio considers total liabilities, upon adoption, there will be an increase in liabilities with no increase in equity, resulting in a higher debt to equity ratio.
  • Negative covenant of additional borrowings – Many banking arrangements have a negative covenant prohibiting the borrower from taking on additional debt. Depending on the terms as defined in the agreement, this may put the company in violation if there were unidentified leases, or incorrectly classified operating leases under the current standard that are now accounted for as finance leases under the new standard.

It is important to understand that the terms and ratios as defined within banking agreements are utilized amongst lenders for the purpose of covenant calculations, as they vary from lender to lender. For example, you would have to consider the definition of debt, as defined within loan documents, and if the new lease obligations fall within the scope of the definition. From an accounting standpoint, finance leases are considered debt while operating leases are not. However, banking agreements may not be as clear cut. Therefore, it is essential to gain an understanding of how the adoption of the new lease standard will impact covenant calculations and banking arrangements.

It is reasonable to assume that most will understand that the addition of operating leases to the balance sheet doesn’t change a borrower’s underlying operations, ability to repay obligations, or cash flows. As such, it’s important to discuss with your lender available options and the ability to include clauses in new agreements to provide flexibility to adopt any future reporting requirements or changes. Some of the most common remedies if the new lease standard creates violations or issues with your banking arrangement are:

  • Frozen GAAP – If the loan agreements contain a frozen GAAP provision, then resulting covenant violations due to changes from GAAP will not cause a violation. However, this can cause additional record keeping for the company by keeping one set of books to comply with GAAP and one set of books to keep track of compliance with covenants in accordance with frozen GAAP at the time of the loan agreement.
  • Semi frozen GAAP – This clause requires the parties to renegotiate the loan covenant if the change in GAAP alters financial ratios.
  • Amendments to covenants/ratios – Work proactively with your bank to amend covenants and set them at levels that will work after implementation of the lease standard.

The key is understanding the impact of the standard on your financial statements so you can speak knowledgably to your lenders and financial statement users. It will be difficult to have these conversations without an understanding of the impact on your company. The effort to determine the impact will be significant. Implementation will involve multiple steps, including, but not limited to the following:

  • Identifying all enforceable leases that fall under the standard. This includes related party leases, which may require determination of what is legally enforceable, and what needs to go on the books. It may come as a surprise how many leases you actually have.
  • Reading lease agreements and compiling the necessary data in order to calculate the ROU asset and lease liability. There are multiple considerations embedded within the standard making it necessary to consider items such as probability to exercise renewal and termination options, the short-term lease exception, and if variable payments can be estimated.
  • Calculating the ROU and present value of the lease liability with an appropriate discount rate. The discount rate must be set based on the appropriate guidance under the standard.
  • Adopting applicable practical expedients depending on your company’s lease portfolio and effect on financial reporting linked to banking arrangements.
  • Making appropriate journal entries to record the assets and liabilities as of January 1, 2022, and the correlating monthly journal entries. Finance and operating leases are both recorded on the balance sheet, however, are accounted for slightly different for purposes of the income statement and statement of cash flows.
  • Compiling appropriate reporting for GAAP, including, but not limited to, weighted average remaining lease term, weighted average discount rate, and lease cost by category (financing, operating, short-term, variable, etc.).

The time and effort to implement the new lease standard will be significant. Delaying implementation until year-end has the potential to cause unnecessary headaches due to items such as possible covenant violations. These potential lending issues in combination with the time commitment to implement the standard could also cause unnecessary delays in completing your 2022 financial statements. The time to start implementation is now so you gain an understanding of the impact on your financial statements and banking arrangements in order to alleviate these issues before they happen.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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