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Lease Accounting Changes Could Jar Bank Covenants

If standards setters require lease accounting on corporate balance sheets, borrowers could break their loan covenants.

Practically lost in the brouhaha concerning the effects of the imminent changes in lease accounting has been the impact they could have on lessees’ relationships with their banks.

A Redesigned "For Lease" Banner

Bankers are warning that altering lease accounting could significantly change a borrower’s balance-sheet profile, possibly making it look more leveraged than it actually is. The changes could also worsen the financial ratios that govern a loan’s covenants, to the point where the borrower is in violation of its agreement with the bank.

With a final vote by the Financial Accounting Standards Board and the International Accounting Standards Board on lease accounting rules possible as soon as mid-March, the focus has been on their advantages for investors and the difficulty corporate finance and accounting departments might have in complying with the rules.

Following vociferous objections by senior corporate finance executives and others to the most recent plan delivered last May, the boards are now mulling new ways to proceed on lessee accounting. Whatever changes the boards do make, however, one thing is nearly certain: the assets and liabilities of what are now operating leases will henceforth be recorded on corporate balance sheets.

No matter how the boards decide to make that happen, the current apple cart of the relations between companies and their lenders is bound to be upset, experts say. That’s because the calculations of many of the key ratios governing bank covenants, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), debt-to-equity (D/E) and return on assets (ROA), are bound to come out a whole lot differently for many companies.

Especially affected by a new system would be companies that retain the right to use equipment or real estate via operating leases. The assets and liabilities of such leases, which are tantamount to rentals, aren’t currently reported on corporate balance sheets. (Lessees are required to put capital leases, in which the lessee essentially agrees to buy the asset with financing help from the lessor, on their balance sheets.)

But under the boards’ lease accounting exposure draft, however, banks would likely see a whole lot more debt and assets on the loan applications of corporations bound by operating leases.

15 thoughts on “Lease Accounting Changes Could Jar Bank Covenants

  1. I laughed at this quote
    “altering lease accounting could significantly change a borrower’s balance-sheet profile, possibly making it look more leveraged than it actually is.”

    This is wrong. The truth is, now an intellectually honest measure of debt (commitments under ALL leases) will be on the balance sheet. Substance over form, ALL leases the run more than a year are debt.

    As companies come to the realization of the high cost of lease financing they are baling out left and right.

    • I also had a chuckle. All obligations, including short-term rentals, employment contracts, long term leases, loan agreements, pension obligations, joint-venture agreements, everything, can lead to financial trouble including bankruptcy. The accounting rule change does not change the obligations of the borrower Any bank that made loans ignoring these non-balance sheet items deserves what they get.

      Years ago, I was researching the rise of lease transactions, and found that indeed borrowers sought out leases to avoid the perceived hit to their leverage. FAS-13 was the first step to close this. One source interviewed S&P and Moody’s as to how FAS-13 would change their ratings. Not at all, the agencies reported. They already capitalized all the lease obligations they could find out about.

      • Always required as presentation and disclosure the future commitment on part of operating leases in the financials which aids the users to factor in the impact while using Financials for purpose,
        The crireria which differntiated between finance lease and operating lease needs clauses that no differentiation will exist.Very interesting thing to keep in mind is that the most lease agreements give the usufruct not ownership for operating leases and the taxes,insurance,repair maintenance rests with lessor which hooks till the end of lease term to the Garage of Lessor, the lessee pays the rent for use and the wear/tear and decline in the market value.If Decision is to bring the OP Lease and Fin Lease at par these resposnsibilities need to be looked into as well.Both leases have termination clauses and attached penalties which are similar except ownership,the rents in Operatig leases are always high?

  2. Quite agree with the readers’ comments. A lease is but indebtedness paid through time, not at some, one (otherwise artificial) termination date. Espial

  3. Operating leases are executory contracts. In a bankruptcy scenario executory contracts can be rejected or affirmed. If rejected, the lease is terminated, the lessor gets its asset back and future rent obligations disappear. So the so-called lease obligation is not debt in bankruptcy. Loan covenants that limit debt are there to protect a lender from the borrower incurring other obligations that would become competing claims in bankruptcy and since an operating lessor does not have equal standing to lenders in bankruptcy lenders have not counted operating lease obligations as debt. So it all depends on your definition of debt. The simple definition that debt is everything owed is too simplistic. There should be a distinction in balance sheet presentation between capital lease obligations (which are debt in bankruptcy) and capitalized operating lease obligations. If the FASB chooses to make that distinction then debt covenants will not be impacted by capitalizing operating leases as non-debt liabilities. If they try to lump all lease obligations into one number then borrowers will have to renegotiate covenants as pointed out in the article. Capitalizing operating leases will be the first executory contract that the FASB will have capitalized. They should take care to avoid unintended consequences of calling something debt when it is debt-like.

    • Substance over form, leases are debt. They are also loan shark financing that drives companies toward bankruptcy. The legal fiction of bankruptcy law has nothing to do with the economic and accounting impact of lease debt.

    • I disagree with Bill on a number of his assertions. First our accounting standards are not set by bankruptcy law. Second, loan covenants that limit debt are not done solely for the purpose of avoiding competing claims. In fact one of the primary reasons for debt limits is the basic fact that additional debt increases the likelihood of economic failure. A bond indenture that includes a debt covenant helps ensure that the credit quality of the underlying does not deteriorate over the life of the bond. The same is true for other forms of debt agreements. Third, it is a silly observation that lenders do not count operating leases as debt. Both lenders and equity analyst routinely recast income statements and balance sheets to reflect the “true” nature of the financial statements when doing analysis or evaluating covenants. Fourth, with respect to executory contracts there is an argument to be made that the accounting for certain executory contracts (say, repo agreements) should be reconsidered. Lastly, in my opinion many operating leases ARE debt, not debt like. For years, companies have avoided disclosing vast amounts of assets and debt on their balance sheets. The substance of these agreements clearly meet the definition of assets and liabilities yet they are found only in the notes.

      • Doug,
        I am on Bill side here. There are big differences in the quality of obligations and other consequences that an operating lease puts on the borrower when compared to a capital lease (or a purchase). Behavior in a bankruptcy situation is just one. Another big one is who holds the risk of an asset revaluation/devaluation.
        Also, in an operating lease the market value of the asset is not expressed: to make it a balance sheet item requires a value assessment that adds a component of uncertainty – and risk of abuse – to the books.
        For all this, disclosing the obligation stemming from operating leases in the balance sheet notes is the best approach for me.

    • The discussion of the bankruptcy scenario is valid and represents a real concern should bankruptcy law change. However, a bankruptcy situation, by definition gives rise to challenging the significant underlying assumption of a going-concern. Financial statements are prepared under the assumption of going concern and the accounting rules and principles are established pursuant to that assumption. While valid concerns are raised by the responder above, they represent a scenario which is not consistent with underlying GAAP.

  4. All comments thus far are correct, but Bill Bosco is *exactly* correct. Differentiation of the disposition of debt and debt-like obligations in bankruptcy (a legal matter, not accounting/reporting) is the distinguishing factor.

    That said, as I’ve written and spoken about for the last five years, including directly with FASB/IASB, let’s go ahead and put leases on balance sheet… the credit ratings agencies do so anyway, as above referenced. Let’s just do it the right way, and without undue administrative burden. UNANIMOUS agreement at the last session I participated in up in Norwalk.

    Re bank covenants: I really don’t think that is a major issue, except for borrowers “on the bubble”.

  5. Impact of lease accounting will be good and bad
    Good – companies will finally be able to answer the question about how many leases they actually have.

    Bad – they may not like the answer, neither will the banks (maybe)

    Good – leases are debt. The rating agencies have known this for years. Now management will know too that leases are an expensive form of debt as well as a “bet” on the future value of an asset important to their business (or maybe not?)

    Bad (maybe) – loan convents could be impacted unless they contain some type of “prior GAAP” language that makes the agreement immune to changes in GAAP. Many agreement already contain prior GAAP language. If not banks maybe willing to adjust tthe agreement for a fee.

    Finally, cash flow remains unaffected meaning it will remain as a key measure when it comes to answering the questions, “What is my real debt capacity? Am I over-borrowed?”

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