Will the new lease accounting standard put you in violation of your loan covenants?

April 4, 2018|Katherine Diederich

Learn how financial covenant ratios will be affected by the new lease accounting standard.

While the analysis and process for deciding whether to finance growth or expansion through leasing or debt agreements has not changed, the new lease accounting standard will impact your company’s compliance with regard to financial covenants and default provisions. This is a direct result of the new lease accounting standard’s requirement to record operating leases as a right-of-use asset and lease liability on the balance sheet.

The impact of the new lease accounting standard is important because many businesses are currently financing projects under previously negotiated long-term financing agreements with thresholds for various leverage, solvency (liquidity), and profitability ratios.

  • Leverage ratios will see the most significant impact as a result of reporting a lease liability. This will impact your debt ratio, debt-to-equity and debt service coverage ratios—measurements of long-term risk. All leverage ratios will be unfavorably impacted by the requirement to include the lease liability as a component of overall debt.
  • The solvency (liquidity) ratios will be impacted because financial statements will now contain a lease liability, classified as both current and noncurrent, with the right-of-use asset classified as noncurrent. This will negatively impact your calculation of working capital and current ratios—the measurements of short-term viability.
  • Profitability ratios will have a mixed reaction to the implementation of the lease accounting standard depending on the variables of lease term, discount rate and lease payments. These variables will impact the value of the right-of-use asset, the corresponding amortization and the interest expense related to the lease liability.

Consider these topics when planning for implementation of the lease accounting standard

Review all current agreements for terms, financial covenants and default language

Restrictive language contained within two-year or longer agreements that will still be relevant after January 1, 2020 (January 1, 2019 for public companies) may produce significantly different results once the lease accounting standard is factored into the calculation. Consider starting the conversation now with all financing relationships to address how this will be approached and if amendments to agreements are necessary.

Project a scenario where you implement early adoption of the lease accounting standard to determine the impact on your current and future financial statements

Start by taking inventory of all current and anticipated operating lease agreements, including term and payment amount. Using an appropriate discount rate, calculate the right-of-use asset and lease liability and record these simulated amounts on the most recent historical financial statement to determine the impact on reporting and ratios.

A frequently asked question is, “What is the cost to implement the new lease accounting standard?”; however, depending on default language in financing agreements, a more important question may be, “What is the cost of nonperformance or violations of loan covenants?”

Timeline for planning

The lease accounting standard is effective for public companies with a fiscal year-end beginning after December 15, 2018 and for nonpublic companies with a fiscal year-end beginning after December 15, 2019.

For the benefit of the readers of financial statements, there will be enhanced comparability disclosure requirements. These comparability disclosures, in essence, require companies to begin calculating and assessing the reporting and impact of the lease accounting standard on their financial statements as early as January 1, 2018. Early implementation of the lease accounting standard is permitted.

For additional insight, check out these other articles related to the lease accounting standard:

Schenck will continue to follow updates on this standard and provide additional implementation guidance. If you have any questions, please contact a Schenck professional at 800-236-2246.

Katherine Diederich, CPA, shareholder, specializes in providing auditing, business reporting and tax planning services to manufacturers and service corporations. Her responsibilities include quality control for compliance with auditing standards as well as providing the bridge between audit findings and useful recommendations for consideration by management.

Tags: Accounting