How New Accounting Rules Could Impact Your Bank Covenants and Purchasing Decisions
A new accounting standard issued by the Financial Accounting Standards Board (FASB) will soon require companies to recognize leases on their balance sheets. In doing so, it could have a major impact on your banking relationship and covenants—and, in turn, impact your access to new capital. Business owners and CFOs need to take note, particularly when it comes to future purchasing decisions as well as accounting for existing leases.
What changes will the new standard bring about?
Essentially, operating leases are giving way to capital leases. Whereas operating leases result in a monthly rent expense, capital leases show up as debt. The new standard, which will go into effect for private companies for years beginning on or after Dec. 15, 2019 (a year earlier for public companies), is designed to bring the United States into alignment with international standards. The U.S. currently uses operating leases, which makes it difficult to compare the financial statements of U.S.-based companies to the rest of the world.
The new standard will apply to all of your major equipment purchases, rental agreements for buildings and property, and even incidentals like copy machines, phone systems, and mailing equipment—for any lease over 12 months.
Here are the three ways this could affect your business:
1. Prepare for changes to your bank covenants
With an operating lease, you have a monthly expense that won't affect your debt-to-equity ratio. Although the move to a capital lease won't necessarily result in a higher monthly payment, it will cause debt to appear on your books. Now that a capital lease will qualify as a capital purchase under the new rules, any covenant or matrix that relates to your debt-to-equity ratio will be affected. This includes tangible net worth requirements as well as other covenants that might include liabilities as part of the calculation.
Also, consider the impact of capitalizing your rent payments under the new rules. For example, if your bank limits your capital expenditures to $500,000 for business equipment, and your building rent of $600,000 is now considered a capital lease, your access to capital could be jeopardized.
Here's the critical piece: Your bank needs to be aware of what's coming so they can amend your covenants if needed.
2. Expect an increased administrative and accounting workload
Whether you're outsourcing your accounting or taking care of it internally, you should get ready for a substantial amount of additional administrative work. For one, the disclosures, reporting and tracking required for capital leases will be substantially more involved. You will now have to take any and all leased equipment (your copy machine, etc.) and put the debt on your books. You'll also have to account for principal and interest payments on your books—a calculation that will vary based on the terms and schedule of repayment.
This last point is probably the most important: If you’re thinking, “Well, if I don’t enter into any new leases after the new standard takes effect, then I don’t need to worry,” stop and think again. This is not true. Because nothing is grandfathered in, all of your existing leases must go on your books as capital leases as well.
3. The age-old question: Buy or lease?
Your business decisions should always be based on the best financing terms, but the new standard puts purchasing versus leasing on a level playing field. Previously, business owners' buy-or-lease decisions may have been partially motivated by accounting treatments or the accessibility of capital in their current bank covenants. By 2020, however, your leased capital expenditures (such as business equipment, facilities, etc.) will be included on your company’s balance sheet as debt, just like your purchased items.
Now may be the right time to review your business model regarding the leasing and procurement decisions you could face in the next few years. Your business management team should collaborate with various stakeholders (real estate, IT, legal, and finance) to review what’s best, given that buying or leasing will require the same accounting treatment.
Get informed as soon as possible so you, your management team, and your bank are ready. The effective date is more than two years away, but that doesn't mean you can afford to wait. We recommend talking with your accountant as soon as possible to:
- Understand the implications the new standard could have on your business accounting and current leases.
- Prepare your numbers and meet with your bank to make sure they know how your covenants could be affected.
- Use these discussions as an opportunity to review your business model in regard to equipment leasing/purchasing.
If you would like to start a discussion about the impact of this major accounting rules change, contact Clint Seehusen. It’s never too soon to plan ahead, especially if you see major lease/purchase decisions on the horizon.
Clint Seehusen (CPA) is a Principal at DS+B | CPAs + Business Advisors in Minneapolis. He provides privately held business owners and executive teams with business growth guidance, accounting efficiency improvement consulting, assurance and financial reporting services. Clint’s expertise includes working with manufacturing, distribution, retail, wholesale and construction companies.