Abstract: The Financial Accounting Standards Board’s new lease accounting standard takes effect this year for public business entities — and fiscal years beginning after December 15, 2019, for other organizations. The new standard may affect banks in two ways: First, it will cause many customers’ balance sheets to swell, which may cause some customers to violate loan covenants. Second, it will have an impact on banks’ own balance sheets, which may affect their capital ratios. This article discusses the ins and outs of the new standard, while a sidebar explains how to add flexibility to loan covenants.
What does the new lease accounting standard mean for banks?
The Financial Accounting Standards Board’s (FASB’s) new lease accounting standard, nearly 13 years in the making, finally takes effect this year for public business entities — and fiscal years beginning after December 15, 2019, for other organizations. By eliminating off-balance-sheet treatment for most operating leases, the new standard may affect banks in two ways: First, it will cause many customers’ balance sheets to swell, which may cause some customers to violate loan covenants. Second, it will have an impact on banks’ own balance sheets, which may affect their capital ratios.
A brief refresher
Under the previous lease accounting standard, leases were classified either as “capital” or “operating” leases. Generally, capital leases transfer ownership of assets to the lessee, while operating leases transfer the right to use assets during the lease term. Capital leases are reported on the balance sheet, but operating leases are not — though they’re disclosed in the financial statement footnotes.
The new standard retains the distinction between operating and capital leases (now called “finance” leases), but requires all leases, other than short-term operating leases (those with terms under one year), to be reported on the balance sheet. For each lease on the balance sheet, a lessee will record 1) a liability reflecting its obligation to make lease payments, and 2) an asset reflecting its legal right to use the leased property (a “right-of-use” or ROU asset). Both are based on the present value of minimum payments under the lease, with adjustments to the ROU asset for certain prepayments, incentives and costs.
Expense recognition under the new standard depends on a lease’s classification. For finance leases, organizations amortize the ROU asset, generally on a straight-line basis, and recognize interest expense and liability repayment over the life of the lease, similar to a loan. For operating leases, organizations generally recognize lease expenses on a straight-line basis, with certain adjustments.
Impact on loan covenants
As the new standard takes effect, borrowers with significant operating leases will experience an immediate increase in assets and liabilities on their balance sheets. As a result, some loan customers may be in technical violation of loan covenants that place limits on their overall debt or require them to maintain certain debt-related financial ratios. Banks should review all loan covenants to evaluate the impact of the new standard.
Whether it will have an adverse impact on borrowers depends in part on how “debt” is defined in the loan documents. The FASB, recognizing that the new standard might create issues with loan covenants, provided for operating lease liabilities to be characterized as “operating liabilities,” rather than “debt.” This action should prevent violations of some commonly used loan covenants. However, covenants that rely on financial ratios that include operating lease liabilities may present a problem.
Banks should consider modifying existing loan covenants to avoid unnecessary breaches and revise covenants going forward to reflect the new lease accounting standard. (See “Adding flexibility to your loan covenants.”) It’s important to recognize that the addition of operating leases to the balance sheet doesn’t change a borrower’s underlying economic situation, cash flow or ability to repay a loan. After all, in most cases, the borrower has been making these lease payments for years — the new standard merely changes the way they’re reported.
Impact on bank capital
For most community banks, the new lease accounting standard isn’t likely to have a significant impact on regulatory capital. But it may affect some banks with substantial operating leases for facilities, equipment and other fixed assets.
This is because the addition of ROU assets to the balance sheet may affect the ratio of capital to risk-weighted assets. The ratio is used to determine capital adequacy.
All banks should review their loan documents and modify them if necessary to prevent inadvertent violations of loan covenants. They should also assess the impact of the new standard, if any, on their regulatory capital levels.
Sidebar: Adding flexibility to your loan covenants
The new lease accounting standard demonstrates how changes in financial reporting can affect compliance with loan covenants, even if the underlying economics are the same. As you review existing loan documents and negotiate new ones, consider incorporating covenant models that provide the flexibility needed to adapt to future changes in Generally Accepted Accounting Principles (GAAP). Two common approaches are:
1. Frozen GAAP. Covenants that contain a frozen GAAP clause provide that changes in financial ratios resulting from changes in GAAP won’t cause a violation. In other words, applicable GAAP is frozen as of the date the loan is made. The problem with this approach is that continuing to apply GAAP that’s in effect at the time the loan agreement is executed, regardless of future changes, essentially requires two sets of books: one to comply with GAAP and one to track compliance with loan covenants.
2. Semifrozen GAAP. A semifrozen GAAP clause requires the parties to renegotiate the loan covenant if a change in GAAP alters financial ratios. This approach avoids the need to keep two sets of books. But it requires the parties to amend the covenant to accommodate their respective needs while reflecting changes in GAAP.