Industry Insights

Proposed Lease Accounting Change Could Impact Your Credit

July 2010
Author:  Matt Coffey

Matt Coffey

Partner

Audit

Construction & Real Estate, Health Care, Manufacturing & Distribution

400 E. Main Street, Suite 200
P.O. Box 1196
Bowling Green, KY 42102-1196 (42101)

Bowling Green
270.781.0111

The credit market has changed dramatically during the last two years. Gone are the assumptions that lenders will waive loan covenant violations. There have been far too many examples of stalled construction projects or constrained operations due to lack of credit. As a result, it is increasingly prudent to proactively monitor and address potential loan covenant violations.

Consider the current proposal by the Financial Accounting Standards Board (FASB) that would require substantially all operating leases to be accounted for as capital leases (click here to read more about the specifics of the proposal), and its effect on loan covenants. If adopted, companies with operating leases would be required to recognize an asset representing its right to use the leased item and a liability for its obligation to pay rentals. For these companies, the proposed change would impact the calculation of the three most common financial loan covenants:  cash flow coverage, balance sheet leverage and capital expenditures. This change could have a material effect on financial loan covenant compliance.

Does This Affect Me?

This proposed change is expected to impact all companies with operating leases. The most significant effect will be for those with a considerable amount of lease expense and/or those with long-term leases—seven to 15 years—that are currently classified as operating.

Lenders often set financial loan covenants based upon a company’s financial position, which has an effect on the overall terms of the loan, including pricing. As a result, companies with stronger financial ratios do not necessarily have more flexibility within their financial loan covenants.

In the example below, assume ABC Company and XYZ Company are identical companies (same cash flow, capital expenditures, operating leases, etc.) with the exception of balance sheet leverage—1.86 for ABC Company and 3.00 for XYZ Company. It would be common practice for a lender to provide a maximum balance sheet leverage covenant to ABC Company of 2.00 while XYZ Company may have a covenant of 3.25. Now, assume that once the proposed lease accounting change is implemented, both companies are required to record a $1 million liability. In both instances, upon adoption of the lease accounting change, the companies do not meet the required financial loan covenants and are in default of their loan agreement, even though there has been no economic change in either company’s financial position.

  Pre-Proposed Lease Change Post-Proposed Lease Change
  ABC Company XYZ Company ABC Company XYZ Company
Total Assets 10,000,000 10,000,000 11,000,000 11,000,000
Total Liabilities 6,500,000 7,500,000 7,500,000 8,500,000
Equity 3,500,000 2,500,000 3,500,000 2,500,000
Balance Sheet Leverage 1.86 3.00 2.14 3.40
Maximum Balance Sheet Leverage 2.00 3.25 2.00 3.25
Covenant Met? Yes Yes No No

What Should I Do Now?

While the proposed lease change is not expected to be effective until 2012 at the earliest, there are potential actions in the near term that can mitigate the impact. First, determine if this change will have a significant effect on you. Summarize all operating leases and estimate the effect that capitalizing existing operating leases could have on your financial statements and loan covenants. If this creates a potential loan covenant violation, there are several approaches to limit the likelihood of future covenant violations, including:

  • Amending the existing loan agreement, so loan covenants specifically exclude the effect of any changes to lease accounting
  • Modifying existing amounts used in setting financial loan covenants
  • Modifying definitions of existing loan covenants to specifically exclude capital leases from loan covenant calculations

In general, lenders perform annual reviews of their loan portfolio and borrowers, often in conjunction with the renewal of annual operating lines of credit. This is an excellent time to discuss this matter with your lender and pursue the possibility of modifying the terms of existing loan agreements. Modifying financial loan covenant amounts and existing loan covenant definitions is relatively straightforward, although it is critical that all existing operating leases and likely future operating leases are considered in your analysis. BKD has assisted clients in having the proposed lease accounting change excluded from loan agreements altogether. The following is example language that was used in a syndicated credit:

“It is acknowledged that any proposed or future change to GAAP relating to lease accounting (the “Proposed Lease Accounting Change”), which is expected to result in all leases being treated the same as or in a manner similar to Capital Leases, shall be disregarded for purposes of determining compliance with covenants contained in this Credit Agreement. All definitions and covenants contained in this Credit Agreement as it relates to leases shall be interpreted using the same accounting policies which are in effect as of the Effective Date (the “Current Lease Accounting”). It is understood that in the event the Proposed Accounting Change becomes GAAP, financial reports delivered by the Borrower shall be prepared in accordance with GAAP and shall include the Proposed Lease Accounting Change once it takes effect. In this event and in order to measure covenants contained in this Credit Agreement, the Borrower shall provide a reconciliation setting forth any discrepancies between (x) such financial reports and (y) the calculations provided without taking into account the Proposed Lease Accounting Change.”

The current credit environment requires companies to vigilantly monitor loan agreement compliance to avoid fees or interest rate increases for noncompliance or any interruption in credit availability. Contact your BKD advisor if you need assistance analyzing the impact of the proposed lease accounting change on your financial statements and/or operations.