Lease Accounting: How to Prepare Now to Avoid Violating Debt Covenants

Written By:

Petra Orquiola

CFOs of private companies and their finance departments have likely been busy in the past months with time-consuming projects such as implementing the complex new revenue recognition standard. An unfortunate consequence may be that they have not begun to prepare for another significant new accounting standard — lease accounting.

The new lease accounting standard will put almost all operating lease contracts on the balance sheet of many companies for the first time. As a result, many companies' liabilities will increase dramatically in the first year of implementation. It might seem like there is plenty of time to get ready for the adoption date of Jan. 1, 2020, for nonpublic companies (Jan. 1, 2019, for public companies). But in reality, the thorough identification of leases, parsing of lease components, allocation of consideration, analysis of potential impact to balance sheets and possible negotiations with lenders will be an involved and possibly lengthy process. Falling behind could put you at risk of violating debt covenants when the new standard goes into effect.

Debt Covenants at Risk

Many debt covenants require a minimum ratio of adjusted net income over debt service payments, or a maximum ratio of debt over net worth. In practical terms, this means companies that depend on financing could find themselves out of compliance with their debt covenant ratios, quite literally overnight, if their covenants don't account for the anticipated increase in liabilities.

How to Get Ready Now

Accounting and finance departments should start collecting lease data as soon as possible, especially if they are reporting to a bank or shareholders. Early analysis will give you plenty of time to identify issues and proactively talk with lenders, negotiate adjustments to covenants and prevent big surprises at year's end.

Below are just a few of the key steps that accounting and finance departments should take as soon as possible in 2019:

  • First, make a list of all current leases, as well as leases you will be entering into between now and 2020.
  • Next, use the new definition of lease to determine the lease and nonlease components of the contracts. A lease is now defined as a contract that conveys the right to control the use of an asset for a specific time in exchange for consideration. The party with the right to direct the use of the asset, along with the right to obtain substantially all of the economic benefits from the use of the asset, is the one that controls its use. If a contract does not meet these criteria, it is not a lease. A nonlease component of a contract includes goods and services provided to the lessee by the lessor that are separate from the right-to-use assets. These might include services such as cleaning, security and maintenance, or goods such as paper and toner included in a lease of a photocopy machine. These nonlease items will be accounted for separately and expensed as they are incurred, although the company has an option to elect an accounting policy to bundle nonlease components with the related lease component.
  • Determine the contract considerations (the benefit you expect to receive from the contract) and allocate the consideration among lease and nonlease components.
  • Look at the terms of each agreement and come up with an amortization schedule for the liability and the asset, using the implicit rate in the lease. Companies with a long list of leases should evaluate whether to purchase software that tracks and amortizes leases.
  • Book entries for current and upcoming leases into pro forma financial statements to determine if they will impact debt coverage ratios beginning in 2020.
  • If debt covenants are likely to be affected, discuss with your lenders as soon as possible to identify agreements or modifications to accommodate the increase in balance sheet liabilities.
  • Consider whether the terms of some leases can be renegotiated with the lessor to qualify as short-term leases (less than 12 months), which are exempt from the lease accounting standard.

This is not a comprehensive list of all the steps you must take to comply with the new lease accounting standard, but it should give you an idea of the complexity and the time required. Companies that underestimate the work involved in identifying leases, gathering data and performing analyses could face difficult questions from lenders and shareholders come 2020.

Wherever you are in your lease accounting implementation process, the lease accounting experts at Williams Benator & Libby, LLP are ready to offer guidance or hands-on help. Give us a call.