Will the new lease accounting standard impact your debt covenants? Looking at three ASC 842 examples
By Alexandra Kemmet
To increase transparency and comparability among organizations, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). The ASC 842 effective date for private companies and nonprofit organizations is for fiscal years beginning after December 15, 2021.
How will this affect your organization’s financial statements?
Prior to adopting ASC 842, any leases that met the criteria for an operating lease were only required to be disclosed in the footnotes, and were not recorded as assets and liabilities on the balance sheet.
Under ASC 842, your organization will have to evaluate whether a right of use asset (long-term asset) and a lease liability (current and long-term liability) are required on the balance sheet. You’ll need to complete this evaluation on all leases.
Can this impact your organization’s debt covenants?
The answer: Yes! While it seems strange, this is a standard that can change your financial statements significantly when nothing has changed economically in your business. Those changes can then have a significant impact on your debt covenants, sometimes changing you from “pass” to “fail”.
Below are some common debt covenants and the potential impacts of ASC 842. These are high level ASC 842 examples, and your management should refer to debt agreements for specific terms and calculations related to financial covenants. The examples also assume no other major changes in other financial activity.
1. Current ratio:
- Calculation: Current assets / current liabilities
- Example requirement: Organization must maintain a current ratio of at least 1.25
- Potential impact of ASC 842: Current assets could remain unaffected, and current liabilities could increase, causing the current ratio to decrease
- Example: You have a 10-year building operating lease that requires monthly payments of $10,000; below are rounded figures (note that these are not exact figures and are only for representative purposes)
| Item | Balances without ASC 842 | Balances including ASC 842 |
|---|---|---|
| Current assets |
$2,000,000 | $2,000,000 |
| Total assets |
$10,000,000 |
$11,200,000 |
| Current liabilities |
$1,500,000 |
$1,620,000 |
| Total liabilities |
$5,000,000 |
$6,200,000 |
| Equity |
$5,000,000 |
$5,000,000 |
| Current ratio |
1.33 — Pass |
1.23 — Fail |
2. Debt-to-equity ratio:
- Calculation: Total liabilities / equity
- Example requirement: Your organization must maintain a debt-to-equity ratio not exceeding 1.10
- Potential impact of ASC 842: Total liabilities could increase, and net worth could stay the same, causing the debt to tangible net worth ratio to increase
- Example: You have a 10-year building lease that requires monthly payments of $10,000; below are rounded figures (note that these are not exact figures and are only for representative purposes)
| Item | Balances without ASC 842 | Balances including ASC 842 |
|---|---|---|
| Current assets |
$2,000,000 | $2,000,000 |
| Total assets |
$10,000,000 |
$11,200,000 |
| Current liabilities |
$1,500,000 |
$1,620,000 |
| Total liabilities |
$5,000,000 |
$6,200,000 |
| Equity |
$5,000,000 |
$5,000,000 |
| Current ratio |
1.00 — Pass |
1.24 — Fail |
3. Fixed charge coverage ratio
- Calculation: EBITDA / (principal payments + interest expense + income taxes + restricted payments)
- Example requirement: As of the last day of each fiscal quarter, the borrower shall maintain a ratio of (i) EBITDA of borrower and its subsidiaries to (ii) fixed charges of borrower and its subsidiaries of not less than 1.05 to 1.0
- Potential Impact of ASC 842: Principal payments made on capitalized lease obligations could increase, causing the fixed charge coverage ratio to decrease
Other considerations
The FASB conducted extensive research, including outreach to lenders. It decided most lease liabilities should be characterized as operating obligations on the financial statements rather than obligations that are equivalent to debt. This may alleviate some debt covenant concerns.
Some organizations may have “frozen GAAP” or “semi-frozen GAAP” clauses in their debt agreements. A “frozen GAAP” clause provides that changes in financial ratios resulting from changes in GAAP will not result in a violation of financial covenants. A “semi-frozen GAAP” clause requires the parties to renegotiate the loan covenant if the change in GAAP alters financial ratios.
Ultimately, it is up to the bank on how they calculate their debt covenants.
ASC 842 lease accounting: Your next steps
Your organization should be very familiar with the details of your debt covenants and begin discussions now with lenders on the potential impact of ASC 842 on those debt covenants.
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