The Ark of the Debt Covenant: Lessees and Liabilities

Real Estate

The Ark of the Debt Covenant: Lessees and Liabilities

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The Financial Accounting Standards Board (FASB) issued a new Accounting Standard Update (ASU) 2016-02, which will change the way both private and public companies are required to disclose their lease obligations.

For lessees, this ASU, which is effective calendar 2019 for public companies and calendar 2020 for private companies, will have a major effect on company balance sheet presentations.  This update is essentially moving operating lease obligations from the footnotes section of the financial statements to the balance sheet.

Upon implementation of this Accounting Standard Update, lessees will be subject to significant financial reporting and business operating implications. The first implication is debt covenants.  A common compliance metric for bank loans is the debt covenant, which requires companies to maintain a specific debt to equity ratio as defined in the loan agreement. Another key covenant is maintaining a minimum working capital ratio.  Now that companies are required to recognize lease liabilities, which can be significant, compliance with certain covenants will be more difficult.

Borrowing capacity is another aspect that will be affected by the new presentation.  Like the debt to equity ratio, an increase in total liabilities can limit overall borrowing capacity.  This has the capability of changing the way companies do business, specifically when deciding whether to lease or purchase new material assets.

One might think that it is only a matter of time before banks and other lending institutions will undergo a complete loan reform and change the specifications of loan covenants and ratio requirements for debt agreements.  This may take some time, but it is worth discussing with lenders now, in advance of the pending implementation.

What can companies do to reduce this looming lease liability? Lessees can negotiate shorter lease terms.  This may seem like an easy solution, but short term leases are not typically appealing for lessors, especially when there is competition for the same space.   Upon expiration of a short-term lease, a landlord may not want to renew a company’s lease and instead sign a longer term lease with another tenant.

One possible solution is a move to a net lease.  In a net lease, the tenant is required to pay some or all of the property expenses that would normally be paid by lessor.  Such expenses include property taxes, insurance, repairs and maintenance charges, as well as utilities.  A lessee that can lower its base rent and increase the amount of property expenses to be paid to the lessor will ultimately reduce its commitment liability on the balance sheet. Under the new standard, only fixed payments are allowed to be included in the calculation of the lease liability.  Since the expenses vary based on usage, they would be excluded from the calculation.  In contrast to shorter lease terms, signing a net lease is more appealing to lessors, as they are still capable of leasing long term and collecting the same amount of money, if not more, from tenants.  The downside to this approach for lessors is the reduction in cost certainty.  In gross leases, cash needs are known.  For net leases, the total cash requirement is unknown.

Early adoption of the Accounting Standard Update is permitted, but it can be a cumbersome conversion depending on the number of leases a given company has.  A lot of thought and consideration needs to go into implementing this new standard, as it will affect the way companies finance their operations.

Ask Our Experts

Rebecca Machinga, CPA, CGMA
[email protected]


To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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