The Impact of ASC 842 on Debt Covenants and Bank Capital Requirements
Last Updated on June 2, 2023 by Morgan Beard
The new lease accounting standards are here. And these guidelines are expanding your balance sheet liabilities. It is estimated $3 Trillion is going onto the balance sheet across the county under ASC 842. So rightfully so, your organization may begin wondering the following:
- What impact does this lease accounting change have on debt covenants and bank capital requirements?
- What potential debt covenant issues may our team encounter from moving operating leases to the balance sheet?
- How will ASC 842 impact our bank capital ratio?
All of which are valid questions! FASB has made it clear that operating leases are lease liabilities and not debt, (thus minimizing the impact on debt covenants). But the potential concern is that lenders may not see it the same way. So to combat this, having your lease data and debt information organized will be an important step to take in case of any unforeseen covenant violation issues.
In addition, bank capital requirements outline that intangible assets are deducted from bank capital ratios, while tangible assets are not. Unfortunately, FASB has not provided definitive guidance on whether an ROU asset represents a tangible or an intangible asset.
There is an ambiguity that comes from not fully understanding how banks and lenders are going to view lease liabilities. In this blog, we will review what FASB has outlined under ASC 842 as it pertains to debt covenants and bank capital requirements as well as how to stay prepared.
FASB Impact on Debt Covenants
FASB has surfaced high-level input on the impact of debt covenants releasing the following guidance:
- ASC 842 characterizes operating lease liabilities as operating liabilities, rather than debt.
- Banks with whom outreach has been conducted state that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change.
- ASC 842 provides for an extended effective date that should permit many entities’ existing loan agreements to expire before reporting under Topic 842. So, that the extended effective date provides significant time for entities to modify those agreements.
Ideally, all of your organization’s debt agreements would have written guidance as to how your operating leases are accounted for under “frozen GAAP” or “semi frozen GAAP” clauses within the ASC 842 framework. But most likely, your debt agreements do not broach this topic. So, it’s best to reach out to your lenders and inquire about the new lease accounting standards and how they impact your debt convents.
Corporate Debt Ratios
With all operating leases now being reported as lease liabilities, it may potentially affect your organization’s debt ratio. With the ASC 842 lease accounting implementation, businesses will need to recalculate their debt ratio as the metrics may skew financial health and even violate debt covenants. So, some organizations may want to have a conversation with their lender and work to renegotiate loan terms.
FASB Impact on Bank Capital Ratio
Bank regulatory capital is the amount of capital that banking regulators require banks or bank holding companies to hold. In other words, the bank ratio capital is expressed as a ratio of capital to risk-weighted assets.
Unfortunately, there is no specific guidance under ASC 842 on whether right-of-use assets are considered tangible or intangible assets. But, Basel Committee on Banking Supervision has issued FAQs on how an ROU asset would be treated for regulatory capital purposes. Under this statement, they clearly consider right-of-use assets as tangible because the underlying asset that is being leased is tangible and as such should be risk-weighted at 100%.
Not only will ASC 842 impact your balance sheet by bringing all operating leases on the books. But it may also impact your debt covenants as well as bank capital ratio. Starting your ASC 842 implementation early will be helpful in collecting all operating leases to understand how they will reflect on your balance sheet. From there, you can examine your debt covenants to stay proactive on debt convents and bank capital ratio. Learn more on how to transition to the ASC 842 lease accounting standards with this post.
Accounting Guidelines Referenced:
- Paragraph BC14 of ASU 2016-02
- Deloitte A Roadmap to Applying the New Leasing Standard (2020) 8.1.1