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Lease accounting: Take advantage of the ASC 842 delay to avoid debt covenant violations

September 19, 2019 Article 4 min read
Josh Richards Curt Hurd
ASC 842’s changes to lease accounting could put your company in violation of debt covenants. We look at how a proactive response can help you avoid problems when the new rules go into effect.
Professionals working at laptopPrivate companies may be breathing a little easier after the Financial Accounting Standards Board (FASB) proposed to delay the effective date of ASC 842, Leases, until 2021. But it’s important to resist the temptation to put off preparations for the new standard: ASC 842 will have a significant impact on balance sheets, potentially resulting in debt covenant violations and increased investor scrutiny. Instead, companies should take advantage of the extra time to adopt the new rules, understand their impact on the business and its financial reporting, and have proactive conversations with lenders, investors, and others before issues arise.

ASC 842 in brief

ASC 842 requires companies to recognize all finance and operating lease assets and liabilities on the balance sheet. Before the new rules, companies kept operating leases off the balance sheet, a practice that meant some companies might be underestimating their liabilities — significantly so, in some cases. According to FASB, ASC 842 will provide much more transparency for investors around leases and related liabilities. As the new standard requires operating leases to be recorded on the balance sheet, it’s expected that more emphasis will be placed on identifying and recording leases that are included in contracts that aren’t traditionally called leases (i.e. embedded leases). Some examples of these may be service contracts where a vendor provides the use of an assets for little or no cost as an incentive for the organization to enter into the contract.

Companies could find themselves in violation of debt covenants — or trying to explain why return on assets has suddenly dropped.

Much more than an accounting change

While ASC 842 will require significant accounting work, it will also have a considerable impact on financial statements. Some estimates suggest the new rules will have a material impact on the balance sheet of 80% of companies, with trillions landing on public companies’ balance sheets this year alone. It will also result in new assets appearing on balance sheets, as companies begin tracking the “right of use asset” for their leased items.

These new balance sheet items will likely change multiple key financial ratios, from debt-to-earnings to return on assets. In some cases, companies could find themselves in violation of debt covenants — or trying to explain why return on assets has suddenly dropped.

It’s not enough to extrapolate from a representative sample of leases: you’ll need to find them all.

The good news is that banks have known for some time that ASC 842 was coming. Lenders understand that the company’s business hasn’t fundamentally changed overnight, but companies should discuss the new rules’ impact with them. The same goes for investors who may not be as current on emerging accounting changes and therefore require companies to explain what’s happening and why. And the earlier these conversations happen, the better.

Don’t wait: Act today on ASC 842

FASB’s proposed ASC 842 delay doesn’t mean you should put preparations for the new rules on the back burner. Instead, be proactive. You and your team need to take action to understand what ASC 842 means to your company — and get started on the significant work involved.

  • Inventory your company’s leases. All of them. Your major leases — for property, vehicles, etc. — are usually easy to find. But leases for equipment, and similar items are often arranged at various levels across the enterprise, from local sales offices to distant plants and beyond. It’s not enough to extrapolate from a representative sample of leases: you’ll need to find them all.
  • Don’t forget about embedded leases. The details of many leases are found inside other contracts — often service contracts. You’ll need to find and review these contracts to extract the lease-related component in order to record and track them properly.
  • Review your lease, lending, and debt agreements carefully. Review your current debt agreements’ wording related to accounting rule changes; some agreements contain provisions (e.g., “frozen GAAP” clauses) to guard against covenant violations, though terms may still need to be renegotiated. Determine what, if any, impact the new lease liabilities from operating leases will have on debt covenants.
  • Contact your lenders early. You don’t want to run into issues after ASC 842 comes into effect. You might incur penalties or other charges as a result of covenant violations, or even require new approvals. Once you understand the new rules’ impact on your balance sheet and debt covenants and have the facts in hand, talk to your bank and other lenders so you can adjust or renegotiate the covenant terms as needed.
  • Identify a suitable software solution. What you’ll need depends on the size, scale, and reach of your company; larger enterprises with thousands of leases will definitely need a robust software solution. It may prove challenging: as public companies implemented ASC 842, many struggled to find or build an effective technology solution that’s compliant with the new standard.
  • Talk to your professional advisors. Your professional advisors can help you understand the likely and potential impact of ASC 842 on your business. Professional advisors can help you with implementing the new rules, including identifying, analyzing, and accounting for leases. They can also bring you best practices and insights drawn from other companies, as well as the resources to help you get the work done and stay ahead.

ASC 842 may be delayed for private companies, but it’s still coming — and preparing for the change represents a significant investment of time and effort. Starting the work today will enable you to identify and mitigate the impact of the new rules on your balance sheet and debt obligations, and minimize the risk of lender-related issues after the rules go into effect. If you have any questions, please give us a call.

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