The Impact on Debt Covenants of Changes in Lease Accounting Standards

In case you haven’t heard, there are new lease accounting standards coming down the pike. If you have a material amount of leases and you have debt covenants to comply with, you probably want to start having conversations with your lenders sooner rather than later, to determine how these leases are going to impact your organization under the new accounting standards.

Background: ASU 2016-02, Leases

Back in February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases. The standard was originally meant to be effective for years beginning after December 15, 2018 (calendar year 2019), for public companies and for years beginning after December 15, 2019 (calendar year 2020). The FASB subsequently approved a delay in the private company implementation to be effective for fiscal years beginning after December 15, 2020 (calendar year 2021). Early adoption is permitted, although we haven’t seen much of this in practice within the healthcare industry.

Under the new standard, operating leases will now be recorded on the statement of financial position as “right-of-use (ROU) assets,” meaning the right to use a specific property, and “lease liabilities,” meaning the discounted lease obligation. The ROU asset is a non-current asset, while the lease obligation can be both current and non-current.

(We’ve discussed our observations based on the implementation of the new lease standard at publicly traded companies here).

Impact on Debt Covenants

Let’s take a deeper look at the individual debt covenants. While we define some common ratios below, each covenant or ratio is unique and should be compared to the original debt agreements to determine how it is defined.

Debt Service Coverage Ratio

Generally, a debt service coverage ratio is calculated by taking net income, and add back depreciation, amortization, interest and other non-cash items divided by the upcoming year’s debt service requirement. Because operating leases will now be on the balance sheet, it is likely that the coverage ratio will be negatively impacted causing some organizations to fall under the required threshold in their debt agreements.

Leverage Ratio

Leverage ratios compare an organization’s total debt against equity or some sort of capital base. With the new lease standard in place, an organization will almost certainly have more debt on its balance sheet.

Action Steps

Determine Your Debt Ratio under ASU 2016-02

First, take an inventory of all of your outstanding lease agreements. These lease agreements can be for anything, including property, vehicles, equipment, copy machines, etc. You might be surprised to find how many leases you actually have.

Second, if you have not done so already, review all outstanding loan agreements to take an inventory of what covenants apply to your organization. Be careful to pay attention to the covenant definitions and calculations outlined in your specific agreements as they can vary significantly.

Third, go back to your most recently completed fiscal year and recalculate your covenants considering the impact of the new lease standard. You may find out that you are still in compliance even with the impact of the new leasing standard. However, you may find out that you are no longer going to be in compliance and can quantify the impact.

Finally, with the above information in hand it is a good time to reach out to your lenders. It is important to get everyone on the same page as to how the covenants are to be calculated. Since public companies have already adopted the new lease accounting standard and loan and credit officers have been trained in the new standard, lenders should already be prepared to address any issues if technical defaults occur. Some options you could try to negotiate, based on the quantified impact of the lease standard on the debt covenants, are as follows:

1. Will the covenants be calculated using “legacy” or “frozen” GAAP, where the covenants will be calculated without regard to ASU 2016-02?
2. Will the loan covenants be renegotiated based on the updated lease agreement standards? For example, instead of a debt service coverage ratio of 1.2, will the lender be okay with a lower standard?

The worst action is inaction. It is much easier to get in front of the debt covenants now as opposed to begging for forgiveness and debt covenant waivers later. Consult your Marcum professional for additional insight and discussion.