April 21, 2020 update: To provide accounting relief and clarity during the COVID-19 crisis, the FASB published an exposure draft with proposals to delay the effective dates for Leases (Topic 842). Find more information here.
After a long wait, the Financial Accounting Standards Board (FASB) approved the new lease accounting standard (Accounting Standards Update 2016-02 “ASU 2016-02”) in February 2016. For public companies, reporting requirements will come into effect for years beginning after December 15, 2018. For all other businesses, these requirements will take effect for fiscal years beginning after December 15, 2019.
Possible impact on lending requirements
The FASB acknowledged that the additional lease liabilities recognized upon adopting ASU 2016-02 could cause some businesses to violate debt covenants or affect access to credit.
However, ASU 2016-02 characterizes operating lease liabilities as operating liabilities rather than debt, so there should be a limited impact on financial ratios commonly used in debt covenants.
Ratios typically associated with loan covenants include:
- Basic fixed-charge coverage
- Current ratio
- Debt service coverage
- Debt to net worth
- Funded debt to EBITDA (earnings before interest, taxes, depreciation, and amortization)
Are you prepared?
Though the standard is not effective for a few more years, there are steps you can take now to prepare:
- Take an inventory of all equipment lease and rental contracts and summarize the terms. The standard only impacts leases with terms of more than 12 months, so focus on the applicable leases.
- Determine if the technology you have in place will meet the new standards; identify IT/software requirements or other options. The new standard requires businesses to calculate the present value of monthly payments on all lease agreements over 12 months, so you’ll want to make sure you have the proper tools to calculate and track that information.
- Review debt covenants. Although the lease accounting changes will have limited effect on debt covenants, discuss fully any implications with your bank or creditors.
Taking these few steps now will put you in a good position to implement the standard when the time comes. Contact your Clark Nuber advisor or Christie Streit for assistance or more information.
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