The International Accounting Standards Board and the US Financial Accounting Standards Board have published proposals relating to the accounting treatment of leases. Comments are due by 15 December 2010 with the intention that a new standard on lease accounting is issued in 2011.  

If the proposals are put into effect as drafted, the current dual accounting system for operating and finance leases will be abolished: borrowers and their lenders will need to consider the effect of this on their facilities agreements and in particular on any financial covenants or restrictions relating to financial indebtedness contained in such agreements.  

What changes do the proposals envisage and why do these matter to lenders?

Whilst industries where operating leases are most extensively used (retailers, hoteliers, aircraft and shipping) will be most affected, the rule change will impact any company that currently accounts for any of its leases as ‘operating leases’.  

The extent to which leases are taken into account for the purpose of financial indebtedness restrictions and financial covenant ratios in facilities agreements will usually depend on the accounting treatment attributed to the particular lease in the preparation of the company’s financial statements. In most cases, the definitions and financial covenants are drafted by reference to the accounting term ‘finance lease’.

Under the current accounting regime, finance leases and operating leases are treated separately. For the lessee, operating leases remain off balance sheet with any lease payments being charged to the profit and loss account (P&L) as an operating expense and therefore not typically considered as debt for the purpose of calculating either financial indebtedness or financial covenants under facilities agreements. Conversely, finance or capital leases are recognised on the balance sheet and consequently are typically included as debt in the financial covenant calculations under facilities agreements.

The proposals envisage abolishing this dual system and adopting a unified approach where all leases are accounted for in a consistent manner with some similarities to the current finance lease treatment. Each lease will need to be considered individually and factors such as discount rates, the period of the lease and lease payments, together with any residual value guarantees or penalties, will all play a part in determining the value and the accounting treatment of any particular lease which will in turn determine the effect of such on the relevant covenants. As a general rule, the following will apply:  

(i) the right to use the asset underlying the lease will appear on the balance sheet as an asset, with the value of the asset reducing over time as the lease term expires;  

(ii) the present value of future payments will appear on the balance sheet as a liability and again will reduce over time but not necessarily at the same rate that the lease asset is depreciated;  

(iii) the interest element of the lease will be charged to the P&L as a finance expense and, once again, this will reduce over time as the amount of the future capital payments reduce; and  

(iv) there will be an annual depreciation charge to the P&L over the life of the lease equal to the reduction in the asset value referred to at (i) above.  

All leases will be referred to as ‘leases’ with the accounting terms ‘operating lease’ and ‘finance lease’ becoming obsolete.  

What is the effect on financial covenants?

As noted, the current dual treatment of leases is reflected in the drafting of ‘financial indebtedness’ and any financial covenants in facilities agreements which typically purport to capture only those obligations in respect of ‘finance leases’. Any restrictions or limits relating to financial indebtedness, for example a permitted basket for finance leases, will therefore need to be reviewed.  

Lenders may argue, following the proposed change and the abolition of the accounting term ‘finance lease’, that any reference in financial definitions to ‘finance lease’ should be interpreted to include any and all leases. Conversely, although somewhat extreme, borrowers could assert that no leases are included.

The potential impact of the change on the financial covenants is summarised in a table (click here to see the table) and analysed in more detail in the Annex to this note (click here to see the Annex).

Will these changes trigger a breach of facilities agreements?

If we assume that the relevant definitions are interpreted to include leases, ‘financial indebtedness’ will be increased as a result of the change in accounting treatment and hence there is a significant possibility that borrowers may be in default as a result, particularly in industries which rely heavily on operating leases (which currently do not typically have an impact on financial indebtedness).

The extent to which the changes will be taken into account when calculating the financial covenants will depend upon the terms of the facilities agreement and whether the borrower is required to deliver its financial statements (a) on the same basis as the original financial statements (i.e. the first set of accounts delivered to the agent on completion), referred to as ‘frozen GAAP’ and standard in leveraged finance transactions or (b) in accordance with GAAP from time to time, referred to as ‘floating GAAP’, which is more typically found in investment grade transactions. Although there is no explicit language in the LMA facilities agreement to support such, it would seem appropriate for a treatment consistent with that applied to the financial covenants to be applied to the determination of financial indebtedness.  

Under a frozen GAAP provision, each set of financial statements has to be prepared on the same basis as the original financial statements, unless there has been a change in GAAP. Where there has been a change, borrowers are required to reflect the changes in GAAP, but in addition the auditors must provide a reconciliation statement to enable the lenders to determine whether the financial covenants have been met on the basis on which they were set. In other words the change in accounting treatment will not affect the calculation of the financial covenants. If however the facilities agreement provides for financial statements to be prepared on the basis of floating GAAP, changes in accounting treatment will be taken into account.  

Conclusion

Parties will be well advised to prepare for the proposed accounting change with respect to the treatment of leases and to consider the likely impact on their financing documentation. This will enable parties to address the issues in advance of the change taking effect.  

Existing Deals

Lenders and borrowers will need to review their facilities agreements to ascertain whether the proposed changes to the accounting treatment of leases will result in leases which have previously been ignored for the purposes of any financial indebtedness restrictions and/or the financial covenants being brought into account. To the extent that they are, a consideration of any floating or, as appropriate, frozen GAAP provisions will be necessary to determine the requisite steps to be taken:  

(i) where facilities agreements provide for floating GAAP there is clearly a potential issue and a need for amendment, waiver or covenant adjustments to be effected to take account of the changes.  

(ii) where facilities agreements provide for frozen GAAP, although there may not be an immediate impact, it may be unclear whether any ‘financial indebtedness’ definitions are ‘frozen’ and even where both financial indebtedness and the financial covenants are ‘frozen’, the delivery of reconciliation statements would require the borrower to maintain two sets of accounts which is not likely to form a viable long term solution.  

New Deals

Lenders and borrowers entering into new or amended facilities agreements should take account of the potential impacts outlined above and ensure that the relevant provisions are drafted so as to anticipate the change and to result in those leases which they agree should be treated as a liability of the company being properly included as such.