Editor’s Note: On July 17th, 2019 the FASB proposed delaying effective dates for four key accounting standards (accounting for leases, credit losses, hedging and long duration insurance contracts). Check out our blog, FASB Proposes Delay in Major Accounting Standards for more information.

Have you read our recent piece, “Will More Businesses Implement Lease Accounting Updates in 2017?” The new lease accounting standards (Accounting Standards Codification, ASC, 842) will impact your company’s financial statements, but beyond that, the new guidance will affect other external reporting, functional, and operational areas—which includes loan covenants.

What is a loan covenant?

These are provisions that banks include in their loan agreements to maintain their position as lender and to improve the probability that the loan will be paid back by the borrower (on time and in full). It is essentially a promise that certain activities will or will not be carried out in regard to the loan and certain targeted metrics have been obtained during the relevant reporting period.

How do the new standards affect loan covenants?

A refresher on the new standard: Operating leases, which are currently off the balance sheet, are, under the new standard, recorded as an asset and liability in most cases.

Impact on company ratios

Many companies have debt arrangements and credit agreements (associated with borrowing or credit facilities) that often contain loan covenants. If these covenants are not passed, the lending institution may consider the loan to be in default and the balance immediately due. Financial covenants are usually expressed as ratios, that the borrower is required to stay above or below. Some of the more common ratios to watch out for that may be impacted include:

• Debt service coverage ratio - Companies typically enter into a debt-service coverage ratio when they borrow from banks. If operating leases are now included in liabilities for covenant purposes and the lease expense is not included in the operating cash flow calculation, this ratio will become substantially skewed.
• Basic fixed-charged coverage - This is used by lenders to evaluate the amount of cash flow on hand for debt service. If operating lease liabilities are included in the calculation, this could cause a company to fail the covenant.
• Current ratio - Current ratios could be affected due to the inclusion of the operating lease liability and right to use asset in the equation and the subsequent amortization of the asset and payment of the liability at different intervals.
• Debt to equity - This is a debt ratio used to measure a company's financial health, calculated by dividing a company's total liabilities by its stockholders' equity, or net worth. This could be affected by the standards change because additional liabilities are now recognized in the balance sheet.

Also, it will be important to review any ratios where intangible assets are removed from the asset base as the right to use asset could be classified as one, and the inclusion of the corresponding lease liability will impact these equations.

The Financial Accounting Standards Board (FASB) pointed out that the additional lease liabilities recognized under ASC 842 would lead some companies to violate debt covenants or impact credit access. However, ASC 842 classifies operating lease liabilities as operating liabilities rather than debt, meaning these amounts should not affect the ratios used in debt covenants. Nevertheless....current credit agreements may not distinguish between the two.

Potential for inadvertent mistakes

The difficulty here is that some companies may inadvertently violate their loan covenants under the new standards. This may seem like just a technicality, but banks may demand immediate payment in full when covenants are violated. Leases that have not shown up on the balance sheet prior to this standard change may bring attention to a bank that the company’s liabilities exceed what the existing loan covenants permit.

Questions on the new lease accounting changes? Contact us.