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The Financial Accounting Standards Board's (FASB) new lease accounting standard (ASC 842) has already been implemented by public companies. Due to the challenges surrounding the COVID-19 pandemic, private companies were granted an extension. Private companies are now required to implement the new lease standard for fiscal years beginning after December 15, 2021. For companies with a December 31 year-end, the new lease standard will need to be implemented effective January 1, 2022.
What can you do to prepare? Below are four steps to help ease the transition to the new lease standard.
Due to the complexity of the new lease standard, today we will dive deeper into step 4. In addition, the guidance provided will be focused on the impact to lessees rather than lessors.
Once you have estimated the impact of the new lease standard on your financial statements, you will want to consider the impact those changes will have on your company's ability to meet the covenant requirements within your current debt agreements.
As indicated in our previous blog articles, the adoption of the new lease standard will generally not result in any changes to net income. Therefore, any profitability or earnings ratio covenants (revenue, operating income, EBIT, net income, etc.) should not be impacted by the implementation of the new lease accounting standard.
However, leverage ratios (e.g., debt to equity, total debt, debt to capital ratios, etc.) are the financial metrics impacted most significantly by the implementation of the new lease standard. As these ratios generally measure a company's relative level of debt, these ratios will increase due to the increase in debt related to the lease liability recorded, as well as the increase in assets related to the right-of-use asset recorded.
Liquidity ratios (e.g., current, cash, quick, etc.) are financial metrics that will also be impacted by the implementation of the new lease standard. These ratios generally measure a company's relative ability to pay off short-term obligations when they come due. These ratios could decrease if the increase in lease liability is greater than the increase in right-of-use assets.
Most banks are aware of the upcoming new lease standard and should be able to assist you in determining how your company's covenant requirements will need to be adjusted in order to account for the changes.
If your debt agreement renewal period is approaching, be sure to consider the changes in your financial statements when agreeing upon the terms for your new agreement. If your debt agreement maturity date is after the first fiscal year-end date after adoption (December 31, 2022 for those companies with a December 31 year end), you should reach out to your bank representative now to help ensure that you can obtain an updated agreement that factors in the impact of the new lease standard on any and all covenant requirements.
Our team of experts has years of experience navigating these types of conversations with lenders. If you have questions about the best changes to make to your covenant requirements due to the implementation of the new lease accounting standard, please contact our team today.