In negotiating a typical loan agreement, the lender and borrower will spend much of their time on the terms of financial covenants – those provisions within the loan agreement which provide the lender with means to measure the financial wherewithal of the borrower and the borrower’s ability to ultimately repay the loan.

Other than loan pricing, financial covenants are probably the most heavily negotiated terms of loan agreements, and lenders and borrowers routinely spend hours putting numbers into various formulas and negotiating appropriate thresholds.

While lenders and borrowers dedicate a significant amount of time to covenant formulas, they tend to spend far less time on the definitions which underlie those formulas.

Most covenant formulas rely on relatively standard definitions of terms such as “indebtedness,” “net income,” and “debt service.” A change is in the works regarding the treatment of leases, however, which will add another layer of complexity into the negotiation of debt covenants.

Capital vs. Operating Leases

The Financial Accounting Standards Board (FASB) defines generally accepted accounting principles (GAAP), which are the basic rules for the preparation of financial statements.

In 2016, the FASB introduced a change known as Accounting Standards Codification 842 (ASC 842), which eliminated much of the distinction between capital and operating leases.

Leases have long been categorized as either “operating” or “capital.” Under an operating lease, the lessee acquires the right to use an asset for a particular period of time, and at the end of the lease term, the asset retains significant value to the lessor. A capital lease, by contrast, is typically considered a financing mechanism under which the lessee is treated as purchasing the asset.

A lease is classified as a capital lease if, among other things, the lessee acquires title to the asset at the end of the term, the lessee has an option to acquire the asset at a bargain purchase price at the end of the term, the duration of the lease term is at least 75% of the useful life of the asset, or the present value of lease payments is at least 90% of the fair value of the asset at the commencement of the lease.

Historically, operating and capital leases have been treated differently on financial statements. Capital leases are treated like debt, and thus appear on a company’s balance sheet. Operating leases, by contrast, appear only as rent expense on a company’s income statement (hence, the term “off-balance sheet lease”).

The Change: Accounting Standards Codification 842

ASC 842 is intended to provide financial statement users with a greater degree of clarity regarding a company’s financial obligations. It makes sense; if a company has a multiyear contractual obligation under a lease to spend a large sum of money as rent, that obligation isn’t really all that different from a multiyear contractual obligation to repay a loan. Under the present system, however, only the loan would appear as debt on the company’s balance sheet.

ASC 842 requires that essentially all leases be included on a company’s balance sheet. For a company with significant rent expense under operating leases, this will have the effect of significantly increasing the company’s long-term debt.

ASC 842 does not completely equate capital and operating leases, however. It creates a separate category of liabilities arising out of operating leases called “operating liabilities” which are technically separate from debt. This continuing distinction between “operating liabilities” and “capital lease liabilities” points to at least one way to minimize the potential disruption caused by ASC 842.

ASC 842 is already in effect for public companies. It was originally to go into effect for private companies and most nonprofits for fiscal years beginning after Dec. 15, 2019, but its application to private companies has been delayed a couple of times, most recently in April 2020.

At present, ASC 842 will be applicable to private companies and most nonprofits for fiscal years beginning after Dec. 15, 2021. Once ASC 842 is fully in effect, it will become a new assumption underlying the ubiquitous phrase “prepared in accordance with GAAP.”

The Issue: Covenant Compliance

Let’s return to the issue of financial covenants, and look specifically at two in particular:

Debt service coverage ratio. The debt service coverage ratio measures a company’s ability to pay its debts by comparing the amount of income that the company has available to make payments on its debt to the total amount of interest and principal payable on that debt for a given period. The higher the ratio, the easier it is for the company to make debt service payments.

Debt to net worth ratio. The debt to net worth ratio measures a company’s ability to pay its debts by comparing the company’s total debt to its net assets. The higher the ratio, the greater the degree of leverage present within the company and the harder it would be for the company to pay its debts by liquidating assets.

Both of these ratios (among many others) initially turn on what is considered to be indebtedness. A typical definition of “indebtedness” in a loan agreement includes not just indebtedness for borrowed money, but many other obligations of the borrower as well, including obligations under capital leases. The same loan agreement likely defines “capital lease” as any lease creating a liability on the borrower’s balance sheet.

And therein lies the problem. Under the pre-ASC 842 regime, only a borrower’s capital leases appear on its balance sheet, so only capital leases impact its debt service coverage and debt to net worth ratios. Going forward, however, the borrower’s operating lease liabilities may also end up being included in these covenant calculations. The borrower’s total indebtedness will increase, and any financial covenant based upon the borrower’s indebtedness will worsen, potentially resulting in an event of default. This is in spite of the fact that there is absolutely no change to the company’s actual cash flow.

An Example: 'ABC, LLC'

Consider the following example.

ABC, LLC (ABC) is party to a fairly typical loan agreement, which was originally drafted several years ago and under which operating lease liabilities will be defined as “indebtedness” once ASC 842 becomes effective.

Under its loan agreement, ABC is required to maintain a debt service coverage ratio of at least 1.25 to 1. ABC’s income available for debt service includes its net income with two add-backs: interest (since that money is already being spent on debt service), and depreciation (since depreciation is a non-cash expense and doesn’t reduce cash available for debt service).

ABC’s liabilities include principal and interest on its bank debt, as well as $25,000 payable each year under both capital and operating leases. See Figure 1.

In the post-ASC 842 scenario, ABC defaults under the terms of its loan agreement, as the additional of operating lease obligations to total debt service reduced its debt service coverage ratio below the minimum required threshold of 1.25 to 1.

So, What Should a Borrower Do?

Borrowers should:

• review current loan agreement covenants, especially the definitions of the terms that are used in each covenant calculation;

• develop a clear understanding of exactly what sorts of additional obligations will be included within covenant calculations given the specific language of their loan agreements;

• review existing leases to confirm exactly what will be the impact of adding those leases to their balance sheets;

• include language within loan agreements providing that they shall be permitted to opt out of changes to GAAP, and continue to demonstrate covenant compliance using the standards which were in effect as of the date of the loan agreement; and

• negotiate future covenants to remove “operating liabilities” from covenant calculations. As noted above, while ASC 842 shifts all lease obligations to a company’s balance sheet, it does not treat capital and operating lease liabilities identically. Borrowers will still be able to define terms such as “debt” and indebtedness” in ways that will keep operating lease liabilities out of covenant calculations.

Conclusion: Work With Lenders

It will be far preferable for borrowers to work proactively with lenders, in order to avoid having to address these sorts of issues in the context of an actual event of default.

To date, it seems that lenders who are following this issue closely are willing to accommodate reasonable requests to adjust covenants and/or permit borrowers to opt out of GAAP changes.

Lenders realize that the issue created by ASC 842 is somewhat artificial. As noted above, while ASC 842 changes how certain obligations of a company are characterized for accounting purposes, it does not change the company’s cash flow or alter its ability to pay its debts, whether they be classified as interest, principal, or rent.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section web pages to learn more about the benefits of section membership.​