A Beginner’s Guide to the New Leasing Standard & Its Impacts on Debt Covenants
One hot topic in the world of construction has been the new revenue recognition standard that became effective on January 1, 2019. But what has not received as much attention, and could have an even bigger impact on financial statements, is the new accounting standard for leases. Because it requires all property, plant, and equipment leases to be shown on the balance sheet, industries that hold numerous equipment and real estate leases will be most affected. Gone will be the days of reporting leases as rental payments in the income statement.
The new standard requires that all leases be presented on the balance sheet, meaning that a lease asset and a lease liability will be presented. There is, however, an exception for short-term leases (i.e., those with a term of 12-months or less).
These leases can continue to be presented off-balance sheet as long as (1) there are no lease extension options that are reasonably certain to be exercised, and (2) an accounting policy election is made, and the policy is applied consistently to all similar classes of short-term leases.
Similar to the old standard, the new one specifies two types of leases: finance leases and operating leases.
A right-of-use asset and a lease liability are included on the balance sheet as a finance lease if any of the following criteria are met:
- There is a transfer of ownership at the end of the lease term,
- There is an option to purchase at the end of the lease term which the lessee is reasonably certain to exercise,
- The term of the lease constitutes a major portion (75-80%) of the remaining economic life of the asset being leased, or
- The present value of the lease payments, plus any guaranteed residual value, equals or exceeds substantially all of the fair value of the asset (90%).
The right-of-use asset is recorded at the present value of the lease payments and amortized (much like depreciation). Any related interest expense on the lease is recognized separately in the income statement.
How does an operating lease differ from a finance lease? Not by much. If a lease does not meet any of the above criteria, then it is classified as an operating lease. A right-of-use asset and a lease liability are still recorded in the balance sheet; however, any related interest expense is not recorded separately. The interest expense is instead calculated as a cost of the lease, and allocated over the entire lease term on a straight-line basis.
Debt Covenant Implications
Since the presentation of the balance sheet, income statement, and cash flow statement are changing as a result of the new lease standard, debt covenants will also be deeply impacted. The following will likely result:
- EBITDA will increase,
- Return on assets will decrease,
- Current ratios will decrease,
- Interest coverage will increase,
- Debt to equity ratios will increase, and
- Leverage ratios could be impacted.
All business owners should be looking at their debt covenants and initiating discussions with their financial institutions well in advance of these new accounting rules.
These changes go into effect for private companies for fiscal years beginning after December 15, 2019. In plain English, this means that most private companies will be implementing the standard for the year ending December 31, 2020—which means there’s still time to begin the conversation with a CPA about the new lease standard and plan for any of its potential financial effects.