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How Changing Lease Accounting Rules Will Impact Loan Financial Covenants

10/01/2011

This is the 45th in a series of brief articles that Moye White is sending to its clients and friends to provide practical insights into opportunities and challenges in today's business and financial world.

The U.S. Financial Accounting Standards Board and International Accounting Standards Board are currently finalizing new rules which will require operating leases to be reported as a liability on balance sheets for companies that use GAAP accounting. Currently, only capital leases are reported as liabilities under GAAP and operating leases are “off-balance sheet”. Under the new proposed rules, lessees will now have to record a lease liability on their balance sheets for what were traditionally classified as operating leases (for the present value of future lease payments).

For certain borrowers, these changes could mean a default under their current loan financial covenants. For example, certain loan financial covenants, such as a quick ratio (current assets divided by current liabilities) or a ratio of total liabilities to net worth, would, once the proposed changes take effect, include all liabilities on the borrower’s balance sheet. For companies with large operating lease portfolios, this could mean an instant default on January 1, 2013, when the standard is currently expected to take effect.

In order to save time and money on amendments later, lenders currently drafting proposals for new loans that will mature (or renew) after the proposed effective date, may want to be proactive and carve out (from any relevant covenants) any operating lease liabilities that may have to be accounted for “on balance sheet” due to the proposed changes.

For more information, please contact Trish Rogers, co-chair of the Financial Institutions Group at (303) 291-7939.

Moye White LLP has prepared this bulletin to provide general information; however this bulletin does not provide legal advice and does not create an attorney-client relationship between the reader and Moye White. No legal or business decision should be based solely on the content of this bulletin.

ABOUT THE AUTHOR

Patricia J. Rogers

Attorney