New Lease Standard ASC 842 and its Impact on Debt Covenants
Adoption of New Leasing Standards For private companies, the Financial Accounting Standard Board (FASB) lease accounting…
Adoption of New Leasing Standards
For private companies, the Financial Accounting Standard Board (FASB) lease accounting standard (ASC 842) will affect periods beginning after December 15, 2021 (calendar-year 2022). This standard brings many operating leases onto the balance sheet this year (2022) and could significantly impact a business’s financial statements, disclosures, and bank covenants. Most capital leases will be reclassified to financing leases under the new lease standards, without significant impact. However, new leases will need to be classified as either financing or operating leases going forward.
All lease agreements (finance and operating) will need to be identified, inventoried, and reviewed by the company’s finance team to identify the changes needed to comply with the new standard. To prepare for the transition to new lease standard ASC 842, finance teams should consider the following steps:
- Identify all leases within your company (real estate, equipment, etc.)
- Summarize and abstract important lease terms
- Calculate and review the initial and subsequent accounting for the leases
- Summarize information needed for footnote disclosures
- If material, separate related party operating leases on the balance sheet from third-party leases
For companies with many locations and leases, such as retail brick and mortar locations, completing the steps above may take a significant amount of time and effort. To increase efficiency, these companies can leverage a lease management software solution. This type of software is specially designed to help companies accurately track and account for their leases under ASC 842 and can facilitate the adoption of new standards as well as future entries.
The most substantial changes occur with the accounting treatment of operating leases. Under the new standard, a lessee will recognize right-of-use assets and related operating lease liabilities on the balance sheet for most leases based on the present value of associated future payments. This value will be determined using the lessee’s incremental borrowing rate, which is designed to reflect the cost of borrowing funds to finance a comparable asset.
Impact on Debt Covenants
With the adoption of ASC 842, companies with debt covenants may face potential impacts, depending on the specifics of those covenants. The following financial covenants may be impacted:
- Fixed Charge Ratio
• You will need to understand how your lender treats the scheduled principal payments on the newly recorded lease obligations as the classification can impact this ratio. If you aren’t sure, you should start having discussions with your lender now.
- Current Ratio
• Many consumer product companies have long-term operating leases. There will be an adverse effect on your company’s current ratio upon adoption, as you will be recording a noncurrent asset and a current and noncurrent liability.
- Tangible Net worth
• Tangible net worth by definition will decline because the right-of-use asset is not a tangible asset and the lease liability is included in total liabilities.
- Debt to Tangible Net Worth
• It is critical to look at the definitions within your debt agreements. Simply looking at the name of this ratio might imply that the input is only debt or bank loans payable. However, debt may be defined as the borrower’s total liabilities. When debt is defined as total liabilities, the adoption of ASC 842 may cause an issue for many companies that have long-term operating leases.
It is critical to read the details of your company’s debt agreements and review all financial covenants to determine the impact on the financial statements from the adoption of ASC 842. Begin discussions with your lenders now, and find out how they are changing agreements, if at all, to accommodate new standards under ASC 842.
Count on Friedman
If you need assistance implementing the new leasing standard, reviewing your leases and debt covenants, or adopting a technological solution, contact your Friedman advisor today.