Disruption is a buzz word these days in the business world as business owners and those around them try to predict what is going to impact their businesses and where those disruptions are going to come from in the near future. Generally, you wouldn’t expect that disruption to come from an accounting standard, but I believe the new leasing standard, formally known as ASC 842, may create a serious impact on businesses who borrow money and those lending the money.
It is common for financial institutions to place some combination of financial covenants in their loans to businesses. Two of the most common covenants are the debt service coverage ratio and the debt to equity ratio. The debt service coverage ratio is a cash flow measure wherein the financial institute looks at your earnings before interest, depreciation, taxes and amortization compared to annual debt service. The debt to equity ratio is a leverage ratio wherein the financial institute looks at your total debt compared to your equity to determine how leveraged the business is at that moment. Generally, the loan documents will set forth minimums the business must maintain for one or both measures and failure to do so could result in the loan being in default.
Current Standard and Impact on Covenants
To understand how the new leasing standard may positively or negatively impact your business’s banking relationship, you need to first understand how the current leasing standard impacts that relationship. Currently when a business enters a lease, whether that is for office space, vehicles, equipment, etc., the lease is accounted for in one of two ways. To know how to account for the lease you first determine whether it is a capital lease or an operating lease. A capital lease is one in which you are basically financing the purchase of the item and there are 4 tests to determine if it is a capital lease, which I will not spend time covering in this discussion, but the most common of the 4 is the bargain purchase price at the end of the lease, i.e., you have the right to purchase the item for $1 or some nominal amount at the end of the lease. All leases that are not a capital lease fall into the operating lease category and they generally represent things that you truly are just renting the use of the asset.
A capital lease is recorded in your business records just like the purchase of a piece of equipment; you would record an asset for the value of the equipment item and a liability for the principle amount of the lease obligation. The asset can then be depreciated just like any other asset and the monthly lease payments act just like a loan payment, wherein a portion of the payment is expensed to interest and a portion reduces the outstanding liability. A capital lease results in you increasing your debt, thus it has a negative consequence on your debt to equity ratio. The interest portion of the payments and the depreciation recorded from the asset impact your P&L by reducing earnings, but for purposes of the debt service coverage ratio they are added back because the ratio takes earnings before interest, depreciation, taxes and amortization.
An operating lease records the entire monthly payment as rent or lease expense, there is no corresponding asset or liability recognized on the businesses books. As such, an operating lease has no impact to the businesses debt to equity ratio. However, because the monthly payments are recorded as rent expense, the payment reduces earnings and thus negatively impacts the debt service coverage ratio.
New Standard and Impact on Covenants
As in the old standard, under the new standard there are still two types of leases now referred to as a finance lease or an operating lease. The factors determining the proper classification have changed and may provide for some planning opportunities but I will not dive into those factors at this time.
Leases that are classified as a finance lease will not be treated much different then under the old standard. Finance leases will be treated as an asset purchase with a corresponding lease liability recorded. The asset will be depreciated and the monthly payments will be recorded the same was as under the old standard, with a portion reducing the lease liability and a portion recorded as interest expense. As such, capital lease still impacts your loan covenants the same way as with the previous standard.
The big change is in how the operating leases are recorded. The new standard requires operating leases to be recorded in a similar fashion to finance leases in that it requires an asset and a corresponding liability to be recorded on the books. The amount of the asset and liability is based on calculating the future obligations owed under the lease and discounting the obligation back to present value. The asset to be record will be labeled a right to use asset with a corresponding lease liability for the same amount. The right to use asset will be amortized over the life of the lease resulting in an amortization expense deduction on the P&L. This change greatly impacts the two financial ratios compared to operating leases under the old standard. As mentioned, operating leases will now result in a liability being recorded on the books, thus increasing liabilities and negatively impacting the debt to equity ratio. However, the amortization of the right to use asset means that now the operating lease will not negatively impact the debt service coverage ratio because amortization is added back in determining earnings before interest, taxes, depreciation and amortization. This will result in a better cash flow ratio then under the old standard.
Why did they do it and when does it take effect
When the new standard was drafted the issue that was being addressed related to the fact that an operating lease can represent a substantial future obligation for a business, yet unless the business issued a full set of financial statements including note disclosures, the reader/end user of the financial statements was unaware of the impact of this substantial obligation. Even if the business issued a full set of statements including note disclosures it was believed that the statement still inadequately informed the reader of the financial impact of operating leases on the balance sheet and cash flow obligations.
The lease standard takes effect for fiscal years ending after December 15, 2019 for public companies and fiscal years ending after December 15, 2020 for all others. However, early implementation is allowed at any time. As such, you could start using the new leasing standard now for your 2016 year ended statements. Financial institutions could start seeing 2016-year end statements using the new standard.
Will it really matter
If you are a company who has struggled to meet the debt to equity ratio covenant in your loan, or you have met it but not with much room to spare, then this may really matter. Do you lease your current office space, warehouse space or factory space? If you do, its most likely an operating lease which means when the new standard kicks in you will have new liability to record which will increase your debt and possibly cause you to now not meet the debt to equity ratio.
If you are a company who has struggled to meet the debt service coverage ratio covenant in your loan, or you have been told that your company doesn’t qualify for a loan because of cash flow concerns, then this may really matter. As above, if you lease your current office space, warehouse space or factory space then most likely it is an operating lease. As such, the new standard now amortizes the newly recorded right to use asset, which moves operating lease payments from a negative impact on cash flow ration to a positive impact on cash flow ratio. If you have a strong balance sheet, but struggle meeting the cash flow ratio, this standard may benefit you.
Those are just two examples of how the new standard may really matter to you. It extends beyond office and building space to include any equipment, land, etc., that you may be leasing under an operating lease structure. It may also have other benefits if you are in an industry wherein your total asset size matters because the new standard includes booking the right to use asset on the books for operating leases, thus increasing the total assets on your balance sheet.
The real questions to be answered relate to how your financial institution is going to handle the new standard. Will they provide exceptions to a company that has always met their debt to equity ratio but now fails it because of the impact of a new accounting standard? Will they tweak the debt service coverage ratio to not add back amortization of operating leases right to use assets? Once you know those answers, you will know where your planning opportunity lies as to whether it’s in early implementation of the standard or how to classify the leases when it takes effect.
Post by Todd Williams.
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