Another Significant Accounting and Reporting Change

| Audit and Accounting

By Mike Alerding     Banks and other commercial lenders are bracing for yet another significant accounting and reporting change that will affect virtually all of their commercial loan customers.  Proposed changes in operating lease accounting will have profound economic, banking and accounting effects on U.S. businesses.

The International Accounting Standards Board (IASB), which currently sets accounting rules for foreign companies, is working with the Financial Accounting Standards Board (FASB), which currently sets accounting rules for U.S. companies, to merge accounting requirements related to operating leases.  Lenders and their lawyers are going to have to go back to the drawing board to come up with new standards for Leverage Ratios, Debt Service Ratios and other standby ratios used in commercial loans.

The IASB and FASB will adopt the IASB standard which will require – now hold on to your loan agreement for a moment – that all operating leases be recorded as both an asset and a liability on their customer’s balance sheets.  The details are still a bit sketchy and won’t be released until later this year when their work is completed, but it looks like the asset, which is entitled something like “Right to Use ________Asset” and the liability will be referred to as something like “Operating Lease Liability”.    At the current time, it looks like the new rules will go into effect as soon as they are passed, with no grandfathering allowed.

Many companies have opted in the past to enter into operating leases versus capital leases in order to keep the liability off their balance sheets.  This was in a long-forgotten era where the income statement and net income actually meant something to lenders and investors.  Following the Enron and other similar scandals and the passage of Sarbanes Oxley, the income statement has taken a back seat to the balance sheet, which reigns supreme now.

For the past 50+ years or so, bank loan covenants were established using only the liabilities that were actually recorded.  Operating leases were off-balance sheet liabilities and, therefore, the liability for future lease payments was included in the notes to the financial statements, but not recorded as a liability on the balance sheet.  Accordingly, traditional leverage ratios, for example, which have historically been 3-1 or 4-1, will now have to be much larger for most companies – maybe as high as 6-1 or 7-1.

Without action on the part of the bank and the customers, bank loan covenants for companies with significant operating lease liabilities will be blown out of the water.  Further, cash flow coverage ratios, which currently include the current portion of long-term debt in the denominator, will also have to be rewritten because there it will include a huge slug of current portion of the operating lease liability.

There will also be some economic impact from these changes outside the banking industry.  Leasing companies and landlords will find downward pressure in lease terms, with many businesses entering into much shorter term leases in order to minimize the effects on their balance sheets.  Further, leasing companies and landlords will have to record a liability as well – for the obligation to provide use of the property.

Over the past 40 years, I have lived through the issuance of hundreds of very significant new accounting pronouncements.  When considered in the context of its overall economic impact, his change might end up being the most significant – and controversial – of them all.

Mike Alerding is a co-founder and Senior Director of Alerding CPA Group, an Indianapolis-based public accounting firm. Visit our website: www.alerdingcpagroup.com.

This post was written by:

Michael Alerding, CPA
Senior Director

Mike has over 40 years of experience in public accounting. He is a prior columnist for The Indianapolis Business Journal and serves on multiple boards throughout Indianapolis. He currently focuses his time on litigation support, business valuations, succession planning consulting and audit and accounting engagements.
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