In August 2010, the Financial Accounting Standards Board and the International Accounting Standards Board proposed changes to generally accepted accounting principles (“GAAP”) related to accounting for leases. The changes are expected to be finalized later this year. If adopted, the proposed changes could significantly impact financial ratios, indebtedness covenants and financial reporting under loan agreements.

Background

The current lease accounting standards in effect under GAAP require leases to be characterized as either operating or capital leases. Leases characterized as capital leases must be reflected on the balance sheet of the lessee. Operating leases may be off balance sheet, but the lessee is required to recognize rent payments as operating expenses charged to the profit and loss account as reflected in its income statements.

The proposed changes to GAAP lease accounting standards will effectively eliminate the distinction between operating and capital leases by requiring the lessee to reflect all leases on its balance sheet. In addition, the lessee will no longer be required to expense the rental payment obligations on its income statement, but will be required to expense any interest portion of the payment obligations and to depreciate the leasehold interest asset.

The Impact on Loan Agreement Terms

The extent to which the proposed changes will impact a loan agreement depends on how the loan agreement treats changes to GAAP. Most loan agreements provide that any changes to GAAP that would affect the computation of financial ratios will either be disregarded or will not be effective unless the parties agree to modifications to the loan agreement that preserve the original intent of the parties in light of the changes to GAAP. This is to ensure that financial covenants will be calculated in accordance with accounting assumptions that were utilized at the time of the closing of the loan when the covenants were modeled.

“If adopted, the proposed changes could significantly impact financial ratios, indebtedness covenants and financial reporting under loan agreements.”

In this case, the proposed changes will not impact the covenant calculations. However, the loan agreement may require the borrower to deliver a reconciliation of its financial statements (and related financial ratio information) before and after giving effect to the proposed accounting changes. Borrowers should consider the cost of compliance, and whether an amendment to the loan agreement should be pursued in light of such costs. If the loan agreement contemplates modifications to preserve the original intent of the parties in the case of changes in GAAP, borrowers should determine whether to include in the loan agreements an express waiver of amendment fees that might otherwise be charged for future amendments related to this proposed accounting change.

A minority of loan agreements provide that changes in GAAP will be given effect without further action of the parties, or unless a party objects to such changes. In these cases, the proposed changes to GAAP will have a greater impact. Typically, loan agreements include capital leases, but not operating leases, as indebtedness both for purposes of leverage ratios and negative covenants restricting indebtedness. The effect of the proposed changes would be to increase the borrower’s indebtedness substantially. Although the recognition of additional interest expense and depreciation attributable to the new accounting for such leases will increase EBITDA for purposes of leverage (particularly in cases where the borrower is in the early part of its lease terms), such increases may not offset the corresponding increase in indebtedness or be sufficient to avoid covenant breaches. Additionally, in loan agreements where pricing is based on the leverage ratio, any increase in the leverage ratio could also result in increased pricing.

A Delicate Balance

Until the disposition of the proposed changes to GAAP is known, to address the potential compliance issues or unintended pricing changes that may arise, loan agreements should include language along the lines of the following to address the competing interests of borrowers and lenders.

“Notwithstanding the foregoing, for purposes of determining compliance with any covenant (including the computation of any financial covenant) contained herein, the effects of any changes in GAAP described in the Proposed Accounting Standards Update to Leases (Topic 840) issued by the Financial Accounting Standards Board on August 17, 2010 (as the same may be amended from time to time) shall be disregarded.”

Such language will help ensure that existing operating leases and future leases that could be characterized as capital leases under the pre-change accounting rules (and not solely as a result of the proposed changes) are not inadvertently excluded from the determination of indebtedness.  

Conclusion

The proposed changes to lease accounting standards present potentially complex issues for borrowers and lenders. Borrowers in particular should monitor the proposed effective date of such changes, assess their loan agreements to determine how changes in GAAP are addressed and determine whether changes to such loan agreements are warranted to neutralize the impact of such changes on covenant compliance, pricing and reporting obligations. In addition, lenders and borrowers should consider addressing the issue in new loan agreements and amendments to existing loan agreements to avoid potential uncertainties at the time the proposed changes become effective.