In February 2016, the Financial Accounting Standards Board (“FASB”) issued FASB Accounting Standards Updated, No. 2016-02 – Leases (Topic 842). The new standard is an effort to converge accounting principles generally accepted in the United States of America (“U.S. GAAP”) and the International Financial Reporting Standards (“IFRS”). The new accounting guidance did not come overnight as the FASB and the International Accounting Standards Board have worked together to re-write the accounting guidance on leases since 2010, and the FASB issued its first exposure draft to revise the accounting for leases in August 2010.
Just like the new accounting guidance on revenue recognition issued in September 2014, the new accounting guidance for leases has been completely re-written in the spirit of convergence. The most significant change for lessees as a result of the new guidance is that all leases with an initial term beyond twelve months will have to be recorded on the balance sheet. That is, lessees are required to recognize on their balance sheet a right-of-use asset and a related lease liability.
The new lease accounting guidance is effective for public companies for fiscal years beginning after December 15, 2018 and for private companies for fiscal years beginning after December 15, 2019 and interim periods beginning the following year. Early adoption is permitted.
Although 2020 may seem to be in the distant future, considering the substantial changes that will happen to most balance sheets as result of the new lease accounting guidance, companies should be pro-active in determining the effects of the new guidance on their financial statements and loan covenants. This is particularly true for companies with loan agreements that include a maximum debt-to-equity ratio covenant or a minimum current ratio covenant.
For example, assume a company has line of credit agreement with a bank that requires the company to maintain a debt-to-equity ratio of no greater than 2.0 to 1.0, and the company has total liabilities of $38 million and total equity of $22 million. In this case, under current U.S. GAAP, the debt-to-equity ratio calculates to 1.7 to 1.0 and the covenant is met. However, now assume that the same company has long-term operating leases and the present value of the future lease payments is $10 million. All of a sudden under the new lease accounting guidance, the debt-to-equity ratio jumps to 2.2 to 1.0 and the company becomes out of compliance with their line of credit agreement.
In short, the new accounting guidance on leases will make companies seem more leveraged than they really are, and may throw them out of compliance with the covenants on their bank agreements. Therefore, companies should start reviewing the effects of the new lease accounting guidance on their financial statements, and working with their bankers to modify the covenants that will otherwise become problematic upon adoption of the new accounting guidance.
For more information about how these new standards will impact you contact your LSL Advisor at 714.569.1000.
