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Implementation of Changes in Accounting Rules May Impact Compliance with Loan Covenants
Clients with debt covenants in their loan documents should be aware that new proposed accounting guidelines for leases will require companies to put on their balance sheet all “right to use assets” with remaining lease terms greater than 12 months. The change would result in increased liabilities on many companies’ balance sheets that could trigger defaults related to debt-to-equity and debt service coverage ratios.
The proposed accounting guidelines will effectively require operating leases to be put on the balance sheet as an asset with a corresponding liability. At its surface, this change appears to simply increase the assets and liabilities by an equal and offsetting amount on the balance sheet in a way that would not affect the company. However, the addition to liabilities for operating lease obligations that have historically been disclosed in footnotes will increase liabilities that could impact debt-to-equity and debt service coverage ratios depending on how they are defined in the loan documents. This unintended result of the proposed change could have a key impact for many companies and their bankers.
Bankers should be aware that the proposed changes could immediately cause their customers to have non-monetary defaults in their loan covenants for debt-to-equity ratios and, depending on the definition, debt service coverage ratios. Operating leases typically disclosed in footnotes will now be re-characterized as debt. Consequently, real estate and other personal property normally not recognized on the balance sheet will need to be included if the lease term has more than 12 months remaining. Bankers and customers should be assessing the impact of the compliance with these new accounting standards to measure whether they will be in non-compliance of their loan agreements. An amendment to the loan documents before there is a default or renegotiated covenants upon renewal may be in order before the credit comes under undue scrutiny from the regulators.
Another interesting offshoot is that tenants will be dis-incentivized in entering into long-term lease agreements. An unintended consequence of this change in accounting for the lessee is that it will likely become more difficult to finance long-term assets with long-term financing since tenants will not commit to longer term leases for fear they may violate their own debt-to-equity or debt service coverage ratios.
Marginally performing borrowers should be concerned that the banks may use these defaults to move credits prior to maturity, especially if they are viewed to be substandard for a variety of reasons (i.e. an industry group falling out of favor, weak collateral coverage, or marginal debt service coverage). Consider utilizing an experienced professional to assist in making the calculations with the loan documents to set a strategy for dealing with this potential risk.
An ounce of prevention is worth a pound of cure and to be forewarned is to be forearmed. We believe it is imperative for management to assess this now and develop strategies for dealing with the consequences of compliance to ensure they don’t get trapped by a loan covenant that impairs their ability to cost effectively access capital to run their business.