Could the new lease standard blow your debt covenants? Why it might be time to talk to your lender.
By this time, you probably have already heard, leases are going to the balance sheet. You may have even heard that for calendar-year private companies, the required adoption is likely being pushed back a year to 2021. But have you considered that the new standard could potentially cause your company to blow its debt covenants? If you have, go ahead and pat yourself on the back. If you haven’t, you may want to continue reading...
What is ASC 842?
ASC 842 stands for Accounting Standards Codification Topic 842. The Financial Accounting Standards Board (FASB) published this new lease accounting standard, which will replace the 42-year-old US GAAP leasing standard, ASC 840.
What happens upon ASC 842 adoption?
Generally, when ASC 842 is adopted, all companies with leases will recognize a “right-of-use (ROU) asset” and “lease liability” and, consequently, any deferred rent obligations existing under legacy GAAP will be removed. The right-of-use asset represents the value of the right obtained to use the property, and the lease liability represents the discounted lease obligation. For most companies who have leases, the asset and liability amounts, when netted together, will approximate the amount of deferred rent that was present under the old standard. If no deferred rent is present, an asset and offsetting liabilities will be recorded. See the example balance sheet comparison below. This shows an example company’s balance sheet before and after the adoption of the new lease standard along with the journal entry:
Take note of these key changes in the balance sheet above:
1) The adopted ROU asset is classified as noncurrent, unlike the lease obligation, which is classified as both current and noncurrent.
2) Total liabilities increased with no changes to equity.
Debt covenants before and after adoption
Now, let’s look at the effects of adoption on three financial statement covenants commonly seen in private companies.
The current ratio
Due to the ROU asset being classified as noncurrent and the lease obligation being broken out between current and non-current liabilities, the current ratio is dramatically impacted by adoption. As seen in the scenario below, our example company went from passing to failing its current ratio covenant upon adoption.
The debt-to-net-worth ratio
Be cognizant of how your loan agreement defines terms used in calculating debt covenants. One may find that the word “debt” is not simply defined as loans payable but can often include capitalized lease obligations or may be defined as total liabilities. For our example company, the lender has defined debt as total liabilities. Due to the increase in liabilities with no increase in equity upon adoption, our example company has yet again gone from passing to failing its debt-to-net-worth ratio.
The debt-service coverage ratio
The debt-service coverage ratio is another calculation where it is important to understand how your covenant inputs are defined and how the ratio is calculated by your lender. In the example below, the lender defined its debt service as the “sum of interest expense, the current portion of long-term debt and capitalized lease obligations (note capitalized obligations, not capital-lease obligations).” The increase in the current portion of lease obligations that were previously not recognized result in a less than desirable consequence for our example company:
The bottom line
As seen in the example balance sheet comparison above, generally, the new lease standard will impact the financial statements of all entities that have leases. If you need help understanding how this will impact your financial statements, your accounting firm should be able to assist you.
Finally, as detailed in the examples above, the adoption of the new standard can have dramatic consequences on debt covenants. While it is true that most disputes around debt covenants will default back to the legacy GAAP at the time of the agreement, it begs the question: Will your covenants be adjusted for the impact the adoption of ASC 842 will have on your financials? If you have a lease and that answer is an unknown, it may be time to have a conversation with your lender now and not after you’ve reported the effects of adopting ASC 842.
