How Will the New FASB Lease Standards Impact Loan Covenants?

How Will the New FASB Lease Standards Impact Loan Covenants?

FASB’s updates to the lease accounting standards, ASC 842, mean that balance sheets will be different when the updates take effect. Starting in 2019 for public companies, and in 2020 for everyone else, liabilities for operating leases will be on the balance sheet for the first time.

What impact will this have on your clients and their relationships with lenders? Some advisors say the sky is falling and all companies will violate their loan covenants. Others believe it will have minimal impact on loan covenants or access to lending. The impact will likely be somewhere in between.

Once ASC 842 is in effect, lessees will record a liability for the present value of future lease payments, and will also record an intangible asset that represents the right to use the asset or assets being leased. The right to use asset will be valued at the amount of the lease liability, adjusted for prepayments, lease incentives or costs to place the asset in service.

This new liability for operating leases, however, won’t be lumped in with debt from capital leases or loans for purchased assets. Instead, FASB retains the distinction between capital leases and operating leases, and created a new liability category specifically for operating leases: operating liabilities.

FASB believes that separating operating lease liabilities from the types of debt that lenders are accustomed to seeing on the balance sheet will minimize the impact. Assuming that lenders maintain this distinction when they calculate the ratios referred to in loan covenants, FASB believes that there will be minimal impact on loan covenants.

Many loan agreements include “frozen GAAP” or “semi frozen GAAP” clauses, which say that any changes to ratios that are caused solely by changes to GAAP either won’t result in default or can be renegotiated in good faith. According to FASB’s outreach to banks, lenders are likely to maintain healthy relationships with borrowers and unlikely to call loans, due to a technical default caused by changes to GAAP.

Some banks that monitor return on assets (ROA) for their borrowers are planning to update their definition of assets to exclude the intangible right to use asset. For these banks, the addition of operating leases to balance sheets may have almost no impact on their lending decisions.

Many lenders have already been including operating lease payments, reported in the footnote disclosures when they make lending decisions. In addition, some lenders only consider the actual secured debt balances – not GAAP basis debt – in their loan covenant calculations.

Perhaps, the most important thing to keep in mind is that the new lease accounting standards don’t have any impact on a company’s cash flow, which is what lenders probably care most about.

What Your Clients Need to Do

Assuming your clients have already begun gathering lease documents, analyzing them, and have developed a system for tracking and calculating the numbers for the financials, here are three things they should do to ensure that they’re not caught unaware by their lenders:

  1. Gather loan agreements: Clients should look at loan agreements that will still be in place when ASC 842 takes effect to determine whether a loan covenant will be impacted, or whether there’s a “frozen GAAP” clause in those agreements.
  2. Reach out to lenders: It’s imperative that everyone is on the same page, so encourage your clients to contact their lenders to find out how they will be treating the new operating liabilities. They may need to renegotiate loan covenants. With a long lead time for non-public companies, there should be ample time to make any needed changes.
  3. Notify investors and other stakeholders: Investors and other interested parties may be unaware of the changes to lease accounting and need explanations about the impact on the balance sheet.

Even though this indicates that the new lease standards will likely have minimal impact on the relationships between your clients and their lenders, it’s still a good idea to make sure your clients and their lenders have a common understanding of these changes.