Management Accounting

Lease Accounting Changes Could Jar Bank Covenants

If standards setters require lease accounting on corporate balance sheets, borrowers could break their loan covenants.
David KatzFebruary 11, 2014

Practically lost in the brouhaha concerning the effects of the imminent changes in lease accounting has been the impact they could have on lessees’ relationships with their banks.

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Bankers are warning that altering lease accounting could significantly change a borrower’s balance-sheet profile, possibly making it look more leveraged than it actually is. The changes could also worsen the financial ratios that govern a loan’s covenants, to the point where the borrower is in violation of its agreement with the bank.

With a final vote by the Financial Accounting Standards Board and the International Accounting Standards Board on lease accounting rules possible as soon as mid-March, the focus has been on their advantages for investors and the difficulty corporate finance and accounting departments might have in complying with the rules.

Following vociferous objections by senior corporate finance executives and others to the most recent plan delivered last May, the boards are now mulling new ways to proceed on lessee accounting. Whatever changes the boards do make, however, one thing is nearly certain: the assets and liabilities of what are now operating leases will henceforth be recorded on corporate balance sheets.

No matter how the boards decide to make that happen, the current apple cart of the relations between companies and their lenders is bound to be upset, experts say. That’s because the calculations of many of the key ratios governing bank covenants, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), debt-to-equity (D/E) and return on assets (ROA), are bound to come out a whole lot differently for many companies.

Especially affected by a new system would be companies that retain the right to use equipment or real estate via operating leases. The assets and liabilities of such leases, which are tantamount to rentals, aren’t currently reported on corporate balance sheets. (Lessees are required to put capital leases, in which the lessee essentially agrees to buy the asset with financing help from the lessor, on their balance sheets.)

But under the boards’ lease accounting exposure draft, however, banks would likely see a whole lot more debt and assets on the loan applications of corporations bound by operating leases.

Oddly, the changes are likely to be favorable for many corporations when it comes to EBITDA. That’s because a large amount of what’s currently operating expense on lessee income statements would be reported on balance sheets as debt and amortization. “If we required minimum EBITDA of $25 million … the customer’s financial performance could deteriorate[,] yet it could meet the covenant,” Roger May, president and board chairman of CBI Equipment Finance, a subsidiary of Commerce Bank, wrote FASB Chairman Russell Golden in September 2013.

Precisely because of the appearance of all that debt, however, bankers could be looking at a raft of borrowers with much gloomier D/E ratios. Thus, “even though the customer’s financial performance has remained the same,” its higher leverage ratio under the proposed lease accounting standard could violate its debt covenant with the bank, wrote May. That would require the borrower to obtain a waiver for breaking the covenant and to re-document the loan request, and both actions would involve fees.

Besides friction with their clients, bankers have other reasons to be touchy regarding changes to lease accounting rules that might make their clients look more indebted. “Changes to financial statements of banks and their borrower customers would be vast,” Dennis E. Dixon, the president of International Bancshares Corp. wrote Golden in October. “The final impact of these changes will probably result in a de facto increase in the regulatory capital requirements of financial institutions. This is especially troublesome because financial institutions are already subject to increased capital levels due to Dodd-Frank and the Basel III capital requirements.”

The current situation in lease accounting is a difficult one for CFOs, because without final guidance from FASB and IASB, it’s hard to know how to approach bankers. However, “what we are suggesting to our client base is, ‘Don’t start doing the accounting yet, because it might very well change. But start talking to your lenders and the people who hold your covenants, because you might be able to reach some accommodation with them,’” advises Richard Stuart, a partner in the national accounting standards group at McGladrey.

One possibility is for finance chiefs to try to persuade their lenders to allow current lease accounting to apply to their covenants, even if new standards are needed to satisfy generally accepted accounting principles, he says.

But when it comes to lease accounting, every silver lining may have its cloud.  “That could be beneficial to you, but you still have the cost of having to keep up another set of books,” Stuart adds.

Image: martymadrid, via Flickr