Off-balance sheet operating leases are an important part of many companies’ financing strategies.  A key attraction of operating leases is that neither leased assets nor lease payments are recorded on a company’s balance sheet under existing accounting rules.  Pending changes to those accounting standards could have a material impact on borrowers’ economic, legal, and compliance obligations under credit facilities.

Overview
On February 25, 2016, the Financial Accounting Standards Board (FASB) which oversees Generally Accepted Accounting Principles (GAAP) in the United States released Accounting Standards Update (ASU) 2016-02, “Leases,” which provides new guidance related to accounting for leases.  This guidance is the result of a coordinated, long-term transparency project of FASB and the International Accounting Standards Board, which oversees International Financial Reporting Standards (IFRS). For public companies, the new standard will become effective for fiscal years beginning after December 15, 2018.  For all other legal entities, the new standard will become effective for fiscal years beginning after December 15, 2019.  The accounting standards permit early adoption.

The new accounting standards will require the assets and liabilities associated with operating leases to be accounted for on a company’s balance sheet.  A lessee will be required to recognize a liability to make lease payments and an asset representing the right to use the leased property during the term of the lease.  The asset and liability will initially be measured at the present value of the remaining payments under the lease.  A lessee is permitted to not recognize lease assets and lease liabilities for operating leases with a term of twelve months or less.

Potential Impacts on Borrowers
Reports from the Equipment Leasing & Finance Foundation have indicated that roughly $2 trillion of liabilities in respect of off-balance sheet leases could be brought onto corporate balance sheets when the new rules are fully implemented.  For some companies, the inclusion of leased assets and lease payment liabilities on a company’s balance sheet will be material and has the potential to impact the economic, legal, and compliance obligations of borrowers under credit facilities in three ways:

• Increased Cost of Funds.  With companies reporting higher financial liabilities, there is the potential for lenders to charge a higher margin on funds made available under credit facilities.  This issue may be particularly acute in existing credit facilities where margins are increased based upon a company’s total leverage ratio or other leverage metric.
• Potential Breaches of Financial Covenants.  The additional balance sheet liabilities created by the new rules may be pulled into the definition of “indebtedness” in many credit facilities.  Such increased indebtedness could increase the numerator in leverage ratio calculations, resulting in breaches.
• Tripping Negative Covenants Restricting Indebtedness.  Most credit facilities have clear limits on the amount of indebtedness a borrower is permitted to incur outside of the facility.  To the extent additional balance sheet liabilities are pulled through to the definition of indebtedness in a company’s credit facility, the increased indebtedness may exceed indebtedness permitted by the credit facility.

Are These Issues Real?
For some borrowers, the upcoming lease accounting changes will result in credit facility issues that must be addressed in negotiated amendments.  However, before raising an alarm and calling your lender, it is important to note a number of potentially mitigating factors.

With respect to the cost of funds, it is generally understood that the credit approval processes for sophisticated lenders and the credit rating agencies include current off-balance sheet operating lease liabilities when analyzing a borrower’s ability to repay indebtedness and service existing lease obligations, especially when the company in question has a material amount of off-balance sheet leases.  Thus, the changes are likely to result in increased on-balance sheet liabilities but not a material reevaluation of the cost of funds.  In any event, it is possible that the cost of funds may change to the extent a company’s lease liabilities recorded on the balance sheet are materially different from the estimates provided in the financial statement footnotes for current off-balance sheet leases.

Additionally, financial covenants, pricing margins based upon leverage ratios and restrictions on incurrence of indebtedness in credit facilities may not be an issue for borrowers for one or more of the following reasons:

• Borrowers having a material amount of off-balance sheet leases typically have credit facilities drafted to incorporate such off-balance sheet liabilities into ratio calculations and negative covenant restrictions, and will not likely require adjustments due to the coming changes.
• GAAP and IFRS do not define “indebtedness” or “EBITDA” and not all definitions of these relevant financial covenant terms incorporate all balance sheet liabilities; therefore, newly on-balance sheet lease obligations may not impact the covenants or leverage calculations.  Also, some borrowers are protected against these changes due to specific carve-outs of operating leases from the definition of indebtedness.
• Many credit facilities base financial covenant calculations on the accounting standards in place at the time of execution of the credit facility.  In these instances, the borrower may have the burden of preparing a separate set of financials used to calculate covenant compliance, but the borrower’s covenants will not otherwise be impacted.
• Even borrowers who do not have “static” GAAP or IFRS provisions in their credit facilities may have express provisions addressing accounting changes that require lenders to negotiate in good faith with borrowers to amend credit facilities to address the impacts of accounting changes (and often GAAP or IFRS is deemed “static” until such negotiations are completed).
• EBITDA calculations may change in the borrower’s favor.  Often lost among concerns about the increase in reported liabilities on the balance sheet is the fact that a large amount of the operating expense attributable to leases on income statements would be reported on balance sheets as indebtedness.  The offsetting change in EBITDA may be sufficient to keep a borrower in compliance with its leverage ratio even if the newly created on-balance sheet liabilities are incorporated into the calculation.
• As noted above, these changes do not become effective for several years, so credit facilities with maturities inside those dates will not be affected.  Borrowers and lenders should, however, take these changes into account when negotiating financial covenants for credit facilities with maturity dates occurring after the effective dates.

In the event one or more of these mitigating factors are not helpful for a borrower under or with respect to its current credit facility, amendments may be necessary.  A borrower and its lender could model a new covenant package and/or pricing matrix implemented now that provides sufficient cushion and appropriate pricing when the accounting changes are effective or agree to a second covenant package and/or pricing matrix that are implemented only when the accounting changes are effective.

Although this article is focused on the potential economic, legal, and compliance impacts to borrowers, another by-product of these accounting changes that will be interesting to observe is the potential that lenders may have to report a borrower client base that is more highly leveraged, which in turn could raise the already increasing regulatory capital requirements of lenders.

In conclusion, while the lease accounting changes have potentially negative impacts to borrowers under credit facilities, borrowers should carefully estimate the financial statement impact of the changes alongside the terms of their credit facilities.  By doing so, they can determine the impact of the accounting changes on existing covenants and evaluate the need to address the impact of these changes with their lenders.