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Prepare Now to Avoid ASC 842 Induced Debt Covenant Violations

Ane OhmBy Ane Ohm

The new lease accounting standard, ASC 842, is effective for fiscal years beginning after Dec. 15, 2021, for nonpublic companies. While most attention has been focused on adding operating leases to the balance sheet for the first time, your clients should be aware that the regulation can also adversely affect debt covenants.

Debt covenants are restrictions that lenders (banks, creditors, debt holders) include in lending agreements to limit the borrower's actions. Adding leases to the balance sheet could dramatically increase both assets and liabilities, resulting in debt covenant violations.

CPA reviewing documents to ensure new ASC 842 lease accounting steps don't affect debt covenantsNo organization wants to violate its debt covenants. To ensure this isn’t a problem, encourage your clients to talk to their banks well before their financial statements begin to incorporate the new lease standard. Debt covenants can be written so clients remain in compliance, even after adding leases to the balance sheet.  

How the Changes Affect Debt Covenants

ASC 842 adds the present value of future lease payments to short- and long-term liabilities, offset by a long-term asset, while leaving the income statement unchanged. For example, a 10-year lease with $10,000 monthly payments can add about $1 million to both assets and liabilities.

How does this impact debt covenants? Well, take the common financial ratio that looks at the total debt of a company and divides it by earnings: a good result would be a low number. Debt covenants often require that ratio to be under a defined number. If you add $1 million in debt while leaving earnings unchanged, you very well could go over that defined number and, therefore, be in violation of that particular covenant.

Another common debt covenant looks at the current ratio, or current assets divided by current liabilities. In this situation, you want the result to be as high as possible. Because ASC 842 adds a long-term asset partially offset by a short-term liability, the current assets are unchanged while the current liabilities increase. Again, the result could inadvertently violate a covenant, even when the fundamentals of the business are unchanged.

Once a debt covenant violation occurs, it can have negative impacts on a business and its ability to access capital.

Violations Can Freeze Credit

When banks lend money to an organization, they expect the organization to strictly comply with stipulated debt covenants.

Failure to achieve this level of compliance can invoke penalties. These penalties can include more frequent or strict reporting requirements, an increase in the cost of capital through higher interest rates, or even frozen or revoked lines of credit. Any or all of these penalties can adversely impact an organization and impede its ability to achieve its core business objectives.

Be Proactive

Organizations with calendar year-end financial statements need to include leases for their Dec. 31, 2022, reporting period. Because waiting can bring unpleasant surprises, organizations should take a proactive approach to avoid unpleasant surprises.

Nonpublic organizations with operating lease portfolios should start talking to their bank immediately to ensure everyone is on the same page with how the new lease standard will affect debt covenants. For those on a calendar fiscal year, your initial application date is Jan. 1, 2021.  

The good news is debt covenants can be adapted for changing circumstances. Ratio results can be changed to reflect added leases. Covenants can require GAAP reporting while excluding added leases from the required ratio calculations. In some cases, non-GAAP reporting might be allowable, although this can have longer-term implications for an organization if it wants to change banks or investors. Any review should include how new disclosure requirements may require changes to debt covenant language.

Software Help

Automated lease accounting software, such as that offered by LeaseCrunch, can help expedite the time needed to implement, transition, account for, and maintain leases under the new lease accounting standard. We’re ready to help simplify the new lease standard for your staff and clients.

Ane Ohm is CEO of LeaseCrunch, a cloud-based lease accounting software company in the Greater Milwaukee area. She can be reached at ane.ohm@leasecrunch.com.

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