FINANCIAL WATCH by Charlie Shannon, CPA Both the preparers and users of a company’s financial statements need to consider how the new requirements under ASC Topic 842 will impact financial reporting. Issued by the Financial Accounting Standards Board (FASB) as Accounting Standards Codification (ASC) Topic 842, Leases , the new guidance requires lessees to recognize assets and liabilities for substantially all leases. In particular, operating leases, which are off balance sheet today, are now re-corded as an asset and liability in most cases. Though the FASB stated that liabilities from operating leases generally won’t meet the definition of debt under U.S. generally accepted account-ing principles (GAAP), a question remains: How will lenders perceive those liabilities? And if lenders view the liabilities capitalized onto lessee balance sheets from operating leases as debt, will this cause companies to violate their loan covenants? To summarize what’s changed: Under current accounting standards, leases that don’t meet the criteria for classification as a capital lease are classified as an operating lease. Operat-ing leases don’t require lessees to record a liability or an asset on their balance sheet. In contrast, under ASC Topic 842, the present value of the lease payments on all leases—including operating leases—must be capitalized onto the lessee’s bal-ance sheet as an asset and a liability with the exception of short-term leases. A How Will the New Lease Accounting Standard Impact Loan Covenants? LTHOUGH most companies are focused on the impact that new lease accounting guidelines will have on their financial statements, the guidelines also impact other external reporting, functional and operational areas—including loan covenants. loan agreements is unlikely to be significant because of the following: ● ● A significant portion of lease agreements contain “fro-zen GAAP” or “semifrozen GAAP” clauses. Accordingly, a change in a lessee’s financial ratios that results solely from a GAAP accounting change either doesn’t result in a debt covenant default or simply requires both parties to renegotiate in good faith. outreach reveals an ongoing commitment to cus-tomers. Banks contacted by the FASB stated they’re un-likely to dissolve a good customer relationship by calling a loan, even if an agreement doesn’t have a frozen GAAP or semifrozen GAAP provision. lease liabilities are operating obligations rather than debt. Based on outreach, this decision by the FASB on disclosure as operating liabilities may substan-tially alleviate issues for some smaller entities with certain debt covenants. The average life of most commercial and industrial loans— based on data obtained by FASB staff—means that many loans will be renegotiated before the effective date for ASC Topic 842 (especially private companies). ● ● Bank ● ● Operating ● ● There’s still time before the guidelines must be adopted. Impact on Company Ratios Many companies have debt arrangements and credit agree-ments associated with borrowing or credit facilities. Often these agreements contain loan covenants that, if violated, trigger a default by the borrower. 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) The FASB acknowledged concern that the additional lease liabilities recognized upon adopting Topic 842 would cause some entities to violate debt covenants or affect access to credit. But because ASC Topic 842 characterizes operating lease liabilities as operating liabilities rather than debt, those amounts shouldn’t affect certain financial ratios often used in debt covenants. In its basis for conclusions, the FASB noted that the ef-fect of Topic 842 on entities’ covenants in existing debt or Further, third parties (such as credit rating agencies and lenders) often rely on lease-related footnote disclosures to determine future contractual obligations or compliance with loan covenants. Rating agencies and financial analysts al-ready estimate operating lease liabilities, and they generally include this amount in the calculation of debt or financial liabilities for rating purposes. Ultimately, industry practice will evolve, and the issue will need to be addressed as com-panies renew their debt agreements between now and the effective date of ASC Topic 842. Presentation of Operating and Finance Leases Under ASC Topic 842, liabilities capitalized from operat-ing leases are to be shown separately from those of finance leases, either on the face of the balance sheet or in the notes to the financial statements. ASC Topic 842 also requires that lease liabilities be shown separately from other assets and 40 JULY/AUGUST/SEPTEMBER 2016 EQUIPMENT LEASING & FINANCE MAGAZINE