A new financial reporting standard issued by the Financial Accounting Standards Board (FASB) may require borrowers to re-evaluate their leasing decisions. The new standard, Accounting Standards Update No. 2016-02, Leases (Topic 842), goes into effect for annual periods beginning in 2019 for calendar-year public companies. Privately held borrowers will have an extra year to implement the changes.
A potential problem is that the new rules, which will require companies to include virtually all leased assets on their balance sheets, may cause borrowers to inadvertently violate their loan covenants. In some cases, borrowers may need to renegotiate loan terms to avoid potential conflicts.
The ins and outs
The controversial new standard is over a decade in the making, inspired by a 2005 callout by the Securities and Exchange Commission for greater transparency about leases. In addition to reporting right-to-use assets and corresponding liabilities for future payments, lessees will include more detailed information in their footnotes.
The updated guidance applies to both capital (or finance) leases and operating leases that have terms of over 12 months. That’s a change from current practice, which requires companies that lease assets to recognize only capital leases on their balance sheets. A capital lease is essentially a type of financing transaction, such as a rent-to-own contract.
Borrowers will continue to differentiate between operating and capital leases on their income statements, statements of cash flow and tax returns. In addition, accounting for lessors (companies that own the assets) will remain largely intact.
Companies with large lease portfolios will feel the biggest impacts of these changes. Examples include stores and restaurants that lease retail space, manufacturers and contractors that lease equipment, and trucking companies and airlines that lease their fleets.
Borrowers are concerned that recording operating leases on their balance sheets may cause them to violate their loan covenants or lead to credit downgrades. In some cases, companies may decide to buy assets outright, rather than lease them, to avoid the hassle of complying with the new accounting rules and take advantage of today’s comparatively low interest rates.
A helping hand
It’s important for borrowers to identify and remedy any potential loan covenant issues before the new lease standard goes live. It’s also an opportunity for them to evaluate and centralize their leasing process. Some companies may decide to terminate, renegotiate or consolidate leases, if their leasing function was ad hoc in the past.
Lenders can work with borrowers to renegotiate existing loan terms. They can also provide additional financing for assets that borrowers choose to buy, rather than lease, in the future.