United States: Accounting For A Headache: Impact Of New Lease Accounting Standards On Credit Agreements

The implementation period for changes in lease accounting standards under United States generally accepted accounting principles ("GAAP") will soon be upon us. For measurement periods beginning after December 15, 2018, GAAP will require public companies to record their operating leases as assets and their payment obligations thereunder as liabilities, while privately held companies must begin adopting these changes after December 15, 2019. Although these changes have been long-anticipated in the market, their impact will no doubt lead to unintended consequences for sponsors and their portfolio companies under their credit agreements. This article discusses potential headaches that these changes may cause for borrowers, as well as certain steps borrowers and their lenders can take to mitigate such headaches.

I. A Summary of FASB Accounting Standards Update No. 2016-02

On February 25, 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2016-02 to Leases (Topic 842),1 which, when implemented, is intended to improve and clarify financial reporting standards with respect to all types of leasing transactions and thereby nullify one of the most widespread existing forms of off-balance sheet accounting. The changes will affect all companies and other organizations that lease any type of asset (including real estate), as well as investors and others who rely on financial statements to understand an entity's financial health, including sponsors and lenders.

Under current GAAP standards (which are established by the FASB), only the assets and liabilities relating to the rights and obligations created by capital leases (leases that function like rent-to-own structures, whereby a lessor essentially finances a lessee's purchase of an asset that the lessee will own at the end of the term) must be reported on a lessee's balance sheet. However, once the FASB's updates are effective, assets and liabilities relating to both a lessee's capital and operating leases must be recognized on an entity's balance sheet (as long as any such lease has a term of more than 12 months). The reportable assets will be the lessee's right to use the assets, and the liabilities will be the lease payments owed by the lessee on such assets (measured as the present value of the lease payments).

As noted above, implementation of this change will be staggered: (1) for public companies, the new rules will apply beginning after December 15, 2018; (2) for privately held and not-for-profit entities, the new rules will apply for fiscal year measurement periods beginning after December 15, 2019 (but not for other measurement periods); and (3) for any other measurement period for privately held and not-for-profit entities, the new rules apply for periods beginning after December 15, 2020. Any entity is permitted to begin applying these standards prior to these deadlines.2

II. Potential Issues under Credit Agreements

Analyzing the potential impact of these new standards on a borrower's credit agreement begins with determining whether the operative definition of "indebtedness" or "debt" in the agreement would include lease obligation liabilities. Definitions of debt in credit agreements (particularly in the middle market) range from a narrow formulation of debt for borrowed money and related debt-like obligations to a broad inclusion of all liabilities under GAAP. To the extent that operating lease obligations constitute "debt" under a credit agreement, such obligations would likely impact the borrower's financial covenants by making borrowers appear more highly leveraged, as the calculation of many common covenants includes a debt component (including the leverage ratio, the debt service coverage ratio and the fixed charge coverage ratio, which frequently appear in leveraged loans). Additionally, any "debt" constituting lease obligations would need to be permitted under the agreement's negative covenant restricting debt: Left untouched, the accounting changes could potentially trigger an inadvertent event of default or result in unintended utilization of the negotiated debt covenant baskets. This impact could result in a diminished ability of the borrower to incur additional debt under its covenants.

III. Potential Solutions

Shortly after the FASB signaled its intention to update the lease accounting standards, market participants began trying to address its impact under credit agreements. The most common "fixes" include:

(1) Explicitly providing that lease accounting standards in effect as of the date of the agreement will apply (even if GAAP changes), using language similar to the following:

"the accounting for any lease (and whether such lease shall be treated as a capitalized lease) shall be based on GAAP as in effect on the closing date and without giving effect to any subsequent changes in GAAP (or required implementation of any previously promulgated changes in GAAP) relating to the treatment of a lease as an operating lease or capitalized lease."

The scope of this "frozen GAAP" provision with respect to leases varies, with some agreements stating that these lease rules apply "for all purposes" and others limited to purposes of financial covenants only. Borrowers should analyze the scope of any such provision and determine whether it is broad enough to cover both financial covenants and negative covenants.

Additionally, relying on such a frozen GAAP provision to mitigate the impact of the lease accounting changes could result in a mismatch of the borrower's audited financial statements required under the credit agreement to be prepared in accordance with GAAP and the use of non-GAAP financial information to calculate the financial covenants. Moreover, if a frozen GAAP provision retains the prior lease accounting standards "for all purposes," the required financial statements would thus also apply the frozen GAAP standard and would not be prepared in accordance with GAAP as in effect at the time. This mismatch would likely result in a qualification by the auditor. Lenders may instead request a second set of financials excluding leases as liabilities to align with calculation of the financial covenants.

(2) Including an agreement to amend the agreement following any change in GAAP to preserve the intent of the agreement. In some instances, this language is limited to changes that impact financial covenant calculations.

While the new lease accounting standard may cause many borrowers to avail themselves of this language, it necessitates an amendment to the agreement, which requires time and expense and often results in frustration. However, if this "fix" is adopted, the parties should ensure that any such amendment also addresses the impact under definitions of debt, financial covenants and negative covenants, and the potential financial statement mismatch discussed above.

IV. Conclusion

Fortunately, with proper attention, these headaches should be a short-term problem for most borrowers. Looking ahead, the best way for borrowers to address the new accounting standards in their credit agreements would be to either (i) include a broad frozen GAAP provision that applies the existing standards for all purposes other than the financial statements, or (ii) address their impact under debt definitions, financial covenants, negative covenants and required financial statements during the initial drafting process or the next amendment. Borrowers should carefully analyze the impact of the lease accounting changes under their credit agreements in advance of implementation to avoid inadvertent defaults or other unintended consequences, and they should discuss how to best address such impact with their lenders and accountants.

Footnotes

1 FASB. (February 2016). Accounting Standards Update No. 2016-02. Accounting standards codification.

2 Id. at 7.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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