You may have heard about the new lease accounting standard that will go into effect for fiscal years starting after December 15, 2019, but you may not be aware of how it may affect your business.
First, a thousand-feet look at the new standard
The new standard does not significantly change the accounting for traditional financing leases, also known as capital leases, so we will not focus on this type of lease. However, the new standard significantly affects the accounting for what are generally known as operating leases. Examples of operating leases include: the lease of a building or office space, the lease of an automobile, and the lease of office equipment (copiers, postage meters, etc.). Before the new lease standard, these operating leases were not included on the balance sheet. The expense related to the rent was shown on the income statement, but there was no asset or liability associated with the lease.
With the new standard, these leases will have an associated asset and liability recorded on the financial statements. The new asset and liability will be a discounted cash flow amount based on the expected term of the lease, including expected extensions, the likely rents, and a discount rate determined by the business based on available financing rates. The asset and liability will always equal each other, and will likely be adjusted as often as formal financial statements are prepared to bring their values in line with current lease terms and expectations. The expense item formerly known as rent will still be included on the income statement, but instead of being labeled rent, the item will have a description such as right to use charge, lease expense, or a similar type description.
Effects of the new standard
The primary way this could affect your business is through changes to business ratios brought about by the new assets and liabilities language. Banks often use ratios such as the following in determining loan covenants for borrowers:
- Current ratio
- Basic fixed-charge coverage
- Debt service coverage
- Debt to net worth
- Funded debt to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
All of these covenants could be affected by the new assets and liabilities created under the new lease standard. Violations of any loan covenants are often considered a default event and cause the related term debt to become immediately callable by the lender.
Addressing the new challenges
Now we can formulate an approach to address some of the challenges that may be created. First, get to know your existing debt agreements. See which agreements have covenants, what the covenants are, and how they are calculated. Second, look at your existing operating leases. One place where you may get significant information regarding operating leases currently in place at your business would be your GAAP financial statements. The GAAP financial statements should have a note that includes some of the pertinent information that you will need to compute the new lease assets and liabilities.
After reviewing your existing operating leases, consider preparing, or having someone else prepare, an estimate of the new lease assets and liabilities that are going to show up on your balance sheet. Add these assets and liabilities to your current balance sheet, then recalculate your bank covenant ratios and see where you stand. If you determine that it is likely that you will be in violation of loan covenants upon adoption of the new accounting standards, then a talk with your banker is in order. Most bankers will recognize the fact that the underlying economics of your business have not changed just because accounting standards have, and they will work with you in modifying your loan agreement to alleviate the issues caused by adoption of the new standard.
Seek help from a CPA
Please consult a professional accountant if you need help in navigating through the new lease accounting standard. He or she can help you identify, and calculate loan covenants, and can assist you with determining the assets and liabilities associated with operating leases currently in place at your business. Finally, your CPA can help you discuss with your banker the issues associated with the new lease standard.
Jon Herdlein is a principal based out of our Buffalo, NY office.