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New Lease Accounting Standards: What Businesses Need to Prepare For

Posted by Cary Giacalone on Tue, Oct 30, 2018

Business team discussing the graphs in the officeIf the financial covenants between your company and your bank are based on GAAP (Generally Accepted Accounting Principles) Financial Statements and include any measure of total liabilities – which most do – you need to be ready for what is coming.

Under an Accounting Standards Update which was issued in April 2016 and effective for 2020 to non-public entities with calendar year ends, the GAAP treatment for leases is changing. This ASU will remap your balance sheet and make your past success with covenant compliance take an unexpected turn for the worse. 

To understand what effect the update will have, we need to summarize the definition of a lease. Historically, there have been two kinds of leases, operating and capital. Operating leases generally included the rental of real estate, office space and other typically long-term items. Conversely, capital leases included short term items such as vehicles and equipment.

From an accounting perspective, operating leases were expensed on a monthly basis and included no balance sheet impact (typically). The cash payment generally matched the expense recorded. Conversely, capital leases recorded the underlying asset as property and equipment and the liability represented the net present value of all cash payments expected under the contract. The main difference at inception – and subsequently through the life of each lease – is that the capital leases were considered debt and long-term obligations and therefore impacted covenant calculations.

As of 2020, capital leases will no longer be alone on the balance sheet. Under the new GAAP requirement, operating leases and capital leases will both be recorded as “right of use” assets and “capital lease obligations.” While this may not sound dramatic, in terms of debt covenants, it is. Since operating leases are generally for expensive and long-term items, the calculation will generally create a large liability that was not there before.

READ MORE: Financial Statements: 5 Key Indicators Business Executives Should Analyze

Let’s take a look at two examples to illustrate the impact: 

A simple company with total liabilities of $1.5M prior to this change may have a small operating lease for its office space. Presume for our example that the lease is for 10 years and requires payments of $2,500 per month at a 3% interest rate. The entry at inception of such a lease will record a liability of $258,904, an increase to the previous liability balance by over 17%.

To take a larger company or more complicated example, let’s use a company with total liabilities of $8M prior to this change with three warehouses each requiring $10,000 monthly payments with 10-year terms and the same 3% interest rate. The entry at inception of these leases will record a liability of $3,106,853, an increase to the previous liability balance of nearly 39%.

To see these changes as your bank will, consider a standard leverage ratio (total liabilities divided by total equity). Covenant requires a ratio of 1.5 or less.

  Small Company Large Company
Prior to 2020:    
Total Liabilities 1,500,000 8,000,000
Total Equity 1,100,000 6,500,000
Leverage Ratio 1.36 1.23
  PASS PASS
2020 and Beyond:    
Total Liabilities 1,758,904 11,106,853
Total Equity 800,000 6,500,000
Leverage Ratio 1.6 1.71
  FAIL FAIL

 

As can be seen above, the extent of this change will vary from company to company and will be determined by the complexity of the business. The underlying question is “Are you ready to explain this to the bank?” 

The best way to do so is to get in front of them long before the change takes place. Some banks will be willing and able to change the covenant calculation to address the new accounting. Some banks may be less willing or able to do so, and by default you will fail the covenant. By speaking with your bank today and identifying their plans for the future, you will be able to ensure that there is no GAAP between your financials and your bank.

For public companies these changes are effective one year earlier. This will force banks to address the changes and make plans before your relationship or calculations are affected. Further, it may change the mindset in the market as to what the loan covenants and calculations should look like or what results to expect.

However, what you do with these upcoming changes is another story. At Concannon Miller, we have done the research and have the tools and strategies ready to embrace these changing requirements.

Contact us today to assess the impact to your company and set up the best practices to track all of the new requirements.

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Topics: Business consulting

Concannon Miller’s unique, holistic and intimate approach to financial health sets us apart from smaller CPA firms with more limited resources as well as mega firms where mid-sized clients struggle for attention. Contact us here to talk about improving your business.

This communication is designed to provide accurate and authoritative information in regard to the subject matter covered at the time it was published. However, the general information herein is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purposes of avoiding tax penalties.

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