How New Lease Accounting Standard Will Affect Borrowers
A decade after efforts first got underway to change lease accounting standards under GAAP, new guidance for lease accounting has finally been issued.
ASU No. 2016-02 will require businesses that lease real estate, vehicles, equipment and other assets for more than one year to report their lease obligations as liabilities on the balance sheet. Currently, operating lease obligations aren’t listed on the balance sheet, which tends to improve leverage, debt service coverage and liquidity ratios. This may increase the chances of obtaining financing.
Once the standards are implemented, borrowers who prepare GAAP compliant financial statements must recognize on the balance sheet assets and liabilities for all leases — both capital (or finance) and operating leases — longer than one year in duration. They must report a right-to-use asset and corresponding liability for the lease payment obligation, discounted to present value.
The new lease accounting standard will have a dramatic and adverse impact on some business borrowers’ leverage ratios, since they will have to list a new liability on their balance sheet. As a result, the standard will fundamentally change how banks underwrite business loans and structure debt covenants, especially for businesses that lease their facilities (like many retailers and professionals, for example).
For example, if lease obligations have not been previously included in the debt service coverage calculation and are treated as the functional equivalent of debt, loans for businesses with significant lease obligations will probably have to be underwritten at a higher debt service coverage ratio, such as 1.5-1 instead of 1.25-1.
Public companies must adopt the new lease accounting standard for interim and annual periods beginning after December 15, 2018, while private companies have an extra year to adopt the standard. Therefore, now is the time to begin preparing for how the new lease accounting standard could affect your borrowers and your bank.