April 11, 2016
Practice Group(s):
Banking & Asset
Finance
Lease Accounting Changes Are Around the Corner:
How Will This Affect Borrowers Under Credit
Facilities?
U.S. Banking & Asset Finance Alert
By Kevin Burnett
Off-balance sheet operating leases are an important part of many companies’ financing
strategies. A key attraction of operating leases is that neither leased assets nor lease
payments are recorded on a company’s balance sheet under existing accounting rules.
Pending changes to those accounting standards could have a material impact on borrowers’
economic, legal, and compliance obligations under credit facilities.
Overview
On February 25, 2016, the Financial Accounting Standards Board (FASB) which oversees
Generally Accepted Accounting Principles (GAAP) in the United States released Accounting
Standards Update (ASU) 2016-02, “Leases,” which provides new guidance related to
accounting for leases. This guidance is the result of a coordinated, long-term transparency
project of FASB and the International Accounting Standards Board, which oversees
International Financial Reporting Standards (IFRS). For public companies, the new standard
will become effective for fiscal years beginning after December 15, 2018. For all other legal
entities, the new standard will become effective for fiscal years beginning after December 15,
2019. The accounting standards permit early adoption.
The new accounting standards will require the assets and liabilities associated with operating
leases to be accounted for on a company’s balance sheet. A lessee will be required to
recognize a liability to make lease payments and an asset representing the right to use the
leased property during the term of the lease. The asset and liability will initially be measured
at the present value of the remaining payments under the lease. A lessee is permitted to not
recognize lease assets and lease liabilities for operating leases with a term of twelve months
or less.
Potential Impacts on Borrowers
Reports from the Equipment Leasing & Finance Foundation have indicated that roughly $2
trillion of liabilities in respect of off-balance sheet leases could be brought onto corporate
balance sheets when the new rules are fully implemented. For some companies, the
inclusion of leased assets and lease payment liabilities on a company’s balance sheet will be
material and has the potential to impact the economic, legal, and compliance obligations of
borrowers under credit facilities in three ways:
• Increased Cost of Funds. With companies reporting higher financial liabilities, there is the
potential for lenders to charge a higher margin on funds made available under credit
Lease Accounting Changes Are Around the Corner
facilities. This issue may be particularly acute in existing credit facilities where margins
are increased based upon a company’s total leverage ratio or other leverage metric.
• Potential Breaches of Financial Covenants. The additional balance sheet liabilities
created by the new rules may be pulled into the definition of “indebtedness” in many
credit facilities. Such increased indebtedness could increase the numerator in leverage
ratio calculations, resulting in breaches.
• Tripping Negative Covenants Restricting Indebtedness. Most credit facilities have clear
limits on the amount of indebtedness a borrower is permitted to incur outside of the
facility. To the extent additional balance sheet liabilities are pulled through to the
definition of indebtedness in a company’s credit facility, the increased indebtedness may
exceed indebtedness permitted by the credit facility.
Are These Issues Real?
For some borrowers, the upcoming lease accounting changes will result in credit facility
issues that must be addressed in negotiated amendments. However, before raising an
alarm and calling your lender, it is important to note a number of potentially mitigating
factors.
With respect to the cost of funds, it is generally understood that the credit approval
processes for sophisticated lenders and the credit rating agencies include current off-balance
sheet operating lease liabilities when analyzing a borrower’s ability to repay indebtedness
and service existing lease obligations, especially when the company in question has a
material amount of off-balance sheet leases. Thus, the changes are likely to result in
increased on-balance sheet liabilities but not a material reevaluation of the cost of funds. In
any event, it is possible that the cost of funds may change to the extent a company’s lease
liabilities recorded on the balance sheet are materially different from the estimates provided
in the financial statement footnotes for current off-balance sheet leases.
Additionally, financial covenants, pricing margins based upon leverage ratios and restrictions
on incurrence of indebtedness in credit facilities may not be an issue for borrowers for one or
more of the following reasons:
• Borrowers having a material amount of off-balance sheet leases typically have credit
facilities drafted to incorporate such off-balance sheet liabilities into ratio calculations and
negative covenant restrictions, and will not likely require adjustments due to the coming
changes.
• GAAP and IFRS do not define “indebtedness” or “EBITDA” and not all definitions of
these relevant financial covenant terms incorporate all balance sheet liabilities; therefore,
newly on-balance sheet lease obligations may not impact the covenants or leverage
calculations. Also, some borrowers are protected against these changes due to specific
carve-outs of operating leases from the definition of indebtedness.
• Many credit facilities base financial covenant calculations on the accounting standards in
place at the time of execution of the credit facility. In these instances, the borrower may
have the burden of preparing a separate set of financials used to calculate covenant
compliance, but the borrower’s covenants will not otherwise be impacted.
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Lease Accounting Changes Are Around the Corner
• Even borrowers who do not have “static” GAAP or IFRS provisions in their credit facilities
may have express provisions addressing accounting changes that require lenders to
negotiate in good faith with borrowers to amend credit facilities to address the impacts of
accounting changes (and often GAAP or IFRS is deemed “static” until such negotiations
are completed).
• EBITDA calculations may change in the borrower’s favor. Often lost among concerns
about the increase in reported liabilities on the balance sheet is the fact that a large
amount of the operating expense attributable to leases on income statements would be
reported on balance sheets as indebtedness. The offsetting change in EBITDA may be
sufficient to keep a borrower in compliance with its leverage ratio even if the newly
created on-balance sheet liabilities are incorporated into the calculation.
• As noted above, these changes do not become effective for several years, so credit
facilities with maturities inside those dates will not be affected. Borrowers and lenders
should, however, take these changes into account when negotiating financial covenants
for credit facilities with maturity dates occurring after the effective dates.
In the event one or more of these mitigating factors are not helpful for a borrower under or
with respect to its current credit facility, amendments may be necessary. A borrower and its
lender could model a new covenant package and/or pricing matrix implemented now that
provides sufficient cushion and appropriate pricing when the accounting changes are
effective or agree to a second covenant package and/or pricing matrix that are implemented
only when the accounting changes are effective.
Although this article is focused on the potential economic, legal, and compliance impacts to
borrowers, another by-product of these accounting changes that will be interesting to
observe is the potential that lenders may have to report a borrower client base that is more
highly leveraged, which in turn could raise the already increasing regulatory capital
requirements of lenders.
In conclusion, while the lease accounting changes have potentially negative impacts to
borrowers under credit facilities, borrowers should carefully estimate the financial statement
impact of the changes alongside the terms of their credit facilities. By doing so, they can
determine the impact of the accounting changes on existing covenants and evaluate the
need to address the impact of these changes with their lenders.
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Lease Accounting Changes Are Around the Corner
Authors:
Kevin Burnett
kevin.burnett@klgates.com
+1.503.226.5775
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