Depending on the size and complexity of a company’s lease portfolio, ASC 842 will either have a significant impact on their balance sheet or a minimal impact. However, regardless of what the dollar impact is to the balance sheet, businesses will still have to analyze and meet quarterly and/or annual debt covenants in order to maintain a positive status with their financial institution. Let’s look at a few ways that adopting ASC 842 may impact common debt covenants:
The debt-to-equity ratio is used to evaluate a company’s financial leverage and is derived by taking total liabilities divided by total equity. If a company’s lease portfolio has a significant amount of operating leases, an operating lease liability will be added into the liability section upon adoption of ASC 842, thus increasing total liabilities. When total liabilities increase, the debt-to-equity ratio will also increase so be aware of this possibility to ensure debt covenants are still being met despite this change.
Audited or Reviewed Financial Statements
Typically, lenders will require either a reviewed or audited set of financial statements to be submitted within 90-120 days after the last day of the fiscal year. Delaying the inevitable of adopting this new guidance could cause potential delays in closing the books and overall readiness for external auditors to perform their work. Adoption of the standard is generally not considered to be within scope of an upcoming 12/31/22 engagement, so the earlier this standard is adopted, the better.
Bank Capital Ratio Impact
Financial institutions and their holding companies are measured based on capital levels. One key ratio that is calculated is total capital as a percentage of risk-weighted assets. When banks calculate this ratio, the new right-of-use asset will need to be risk-weighted at 100% as it will be treated as a tangible asset. If significant, this may cause a noticeable change in the resulting ratio.
Without question, the adoption of ASC 842 will have significant implications for your company’s banking covenants. While it is true that most disputes around debt covenants will default back to the legacy GAAP at the time of the agreement, it begs the question: Will your banking covenants be adjusted for the impacts that ASC 842 will have on your financials? If you have a lease portfolio at any level, and the answer to this question is an unknown, it may be time to have a conversation with one our CSH lease accounting specialists and/or your lender(s).
Is your business compliant with the new lease accounting standard?
See our podcast, “Countdown to ACS 842 Readiness”