Revising lease terms to avoid the new accounting rules

Debt-strapped private companies have been exploring ways to avoid using the lease accounting rules for new contracts. Why? Some fear that implementing the guidance would cause them to violate loan covenant agreements with lenders that limit the amount of liabilities they’re allowed to carry. But there are ways to safeguard against this potential pitfall.

Accounting for leases

The new leases standard is a historic accounting change, aimed at bringing transparency to investors about off-balance-sheet-type figures companies hold. In 2005, the Securities and Exchange Commission (SEC) estimated that public companies, combined, had roughly $1.25 trillion of off-balance-sheet-operating lease commitments.

In 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). The effective date for calendar year-end public companies was Jan. 1, 2019. The FASB recently voted to defer the effective date for private companies and nonprofit organizations from 2020 to 2021.

The updated guidance requires companies to identify leases as either an operating lease or a financing lease. For both types of leases, they will be reported as long-term leased assets (referred to as a “right-of-use asset”) and related leased liabilities on the balance sheets. For operating leases, the liability is not considered debt and, therefore, will not impact debt ratios. For financing leases, the liability is considered debt, so it will impact debt ratios. For some large companies, it means billions of dollars of lease obligations coming on their books, representing thousands of contracts.

To adopt the changes, companies must evaluate their contracts to determine whether they contain embedded leases and, therefore, would qualify for the rules.

At-risk sectors

Highly leveraged companies (meaning those with a lot of debt) need to be mindful of the leases standard. Borrowers with loan covenants that limit the amount of debt on the balance sheet or that require a minimum working capital balance also should be cautious; implementing the leases standard could trip their loan covenants. Examples of sectors affected by the leases standard include real estate and manufacturing firms that lease equipment, buildings, and other hard assets.

Retailers are especially concerned about bringing leased assets to their balance sheets. The retail sector has been hit with a large number of bankruptcies over the past decade, stemming from a tidal wave of online competition. For example, David’s Bridal, Sears, and Nine West Holdings filed for bankruptcy last year. Retailers are concerned that an increase in their debt ratios from implementing the leases standard might cause lenders to panic and call their loans.

“The retail sector has commanded one of the highest default rates among U.S. industries over the past few years,” Moody’s Investors Service announced earlier this year.

Short term vs. long term

The updated leases standard applies only to leases of more than 12 months. To avoid having to apply the new guidance, some companies have been opting for short-term leases. Others are using “evergreen” leases, where either party can cancel at any time after 30 days, but there’s an implicit understanding that they’re in it forever. An evergreen lease wouldn’t technically be considered a lease under Topic 842 — even if the lessee renewed on a monthly basis for 20 years.

This might not be the best approach from a financial perspective because the lessor would likely charge a higher price for the transaction. But some companies prefer this approach because they don’t want to report more debt on their balance sheet or to trip loan covenants.

There’s also a risk that short-term and evergreen leases won’t be renewed at some point. For example, suppose a clothing boutique has been located on Main Street for 30 years. Then its lessor suddenly decides to rent the space to another tenant despite an implied agreement to renew the lease into perpetuity. The store would have to find an alternate space to rent, move, and advertise its new location to customers within a relatively short period. This could be costly and inconvenient — and it could seriously interrupt business operations.

Work with lenders

Rather than revising contract terms, some private companies are talking to their lenders about the upcoming changes to the lease accounting rules. The FASB’s one-year deferral of the standard’s effective date will buy companies time to understand how the changes will affect their financial statements and meet with their lenders. In some cases, banks may need to amend borrowers’ loan covenants to prevent violations when the changes go into effect.

Adopting the new rules may require a substantial amount of effort, but KraftCPAs can help. In addition to helping you record leases properly, our professionals can brainstorm with you on ways to minimize any negative side effects and meet with your lenders to get them up to speed on what’s coming.

© 2019

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