Lease Accounting, Financial and Other Covenants

In August 2010, the FASB and IASB issued a joint exposure draft ' Leases. The exposure draft creates a new accounting model for both lessees and lessors, and eliminates the concept of operating leases. All outstanding leases will be subject to the new lease accounting rules ' there will be no grandfathering of existing leases. The boards are expected to issue a final standard in June 2011, but they have not yet decided on an effective date for the new rules. This article summarizes the new accounting model for lessees and addresses the impact the new model may have on financial and other covenants typically found in financing agreements, where the lessee is the borrower. (The new accounting model for lessors is beyond the scope of this article.)

Summary of the New Accounting Model for Lessees

• Lessees will recognize a right-of-use asset for the lease term and a liability for their obligation to make lease payments. “Off-balance-sheet” leases will no longer exist.
• Except for short-term leases (leases with a term of 12 months or less), the present value of the lease payments will be used in the initial measurement of the obligation to make lease payments, discounted by using the lessee's incremental borrowing rate or the rate the lessor charges the lessee, if it can be readily determined. The right-of-use asset will initially be measured at the same amount plus any recoverable initial direct costs, such as commissions and legal fees.
• If the lease includes renewal options or early termination options, the lessee will need to estimate the probability of occurrence for each possible term in determining the lease term.
• Under an expected outcome approach, the lessee will recognize contingent rentals and residual value guarantees as part of the lease liability.
• Under the new rules, a purchase option will be accounted for only when it is exercised. The exercise price will not be considered a lease payment but part of the cost of acquiring the underlying asset. However, purchase options do factor into the analysis of whether the lease represents a purchase or sale of the underlying asset. If the lease contains a bargain purchase option, it generally would be treated as a purchase and sale under existing GAAP and therefore it would be excluded from the new accounting rules.
• For leases previously classified as operating leases, rent expense will be replaced with amortization expense and interest expense. Amortization of the right-of-use asset will generally be on a straight-line basis. Interest expense will be front-end loaded, like interest on an amortizing mortgage. Therefore, net income could be lower in the first years of the lease under the new accounting rules than it would have been under current operating lease accounting. However, EBITDA would be higher because rental expense is not recorded.
• For leases previously classified as capital leases, the existing capitalized assets and lease obligations, which are based on the greater of the present value of minimum lease payments and fair value, will be replaced with the right-to-use measurement and the present value determinations described above.
• The new rules will require the lessee to periodically reassess the carrying amount of the obligation each reporting period “if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period.”
• The new rules will result in additional temporary differences for income tax accounting purposes. State and local taxes may also be affected.

Example

Company A enters into an equipment lease. The lease term is noncancelable for five years, with no renewal options. The agreement is for quarterly lease payments of $100,000 per quarter. Company A's incremental borrowing rate is 8%. The agreement does not include a purchase option or a residual value guarantee.

The first step is to estimate the lease payments over the five-year lease term. The lessee estimates that the present value of the lease payments will equal $1,635,143. This is what gets recorded on the balance sheet on day one as the “right-to-use asset” and the corresponding obligation.

Table 1, below, compares the income statement impact in the first year. Under the proposed approach, the expense is front-ended and therefore higher in the first year than what it would have been under current operating lease accounting.

[IMGCAP(1)]

Effect on Financial and Other Covenants

The effect of the new accounting rules on financial and other covenants is manifold. The first thing to check is whether the applicable financing agreement addresses changes in GAAP. If GAAP is “frozen” as of the date of the financing agreement, then the lessee-borrower is protected.

An example of such a provision is as follows (emphasis added):

If at any time any change in GAAP would affect the computation of any financial ratio or requirement set forth in any Loan Document, and either the Borrower or the Required Lenders shall so request, the Administrative Agent, the Lenders and the Loan Parties shall negotiate in good faith to amend such ratio or requirement to preserve the original intent thereof in light of such change in GAAP (subject to the approval of the Required Lenders); provided that, until so amended, (i) such ratio or requirement shall continue to be computed in accordance with GAAP prior to such change therein and (ii) the Borrower shall provide to the Administrative Agent and the Lenders financial statements and other documents required under this Agreement or as reasonably requested hereunder setting forth a reconciliation between calculations of such ratio or requirement made before and after giving effect to such change in GAAP.

Assuming the financing agreement does not have such a provision: What is the impact of the new accounting rules in that situation?

Financial Covenants

The new accounting rules may affect compliance with existing financial covenants. The following are some examples:

• Leverage (Debt to Net Worth or Debt to EBITDA may not exceed x:1.0). As indicated above, the present value of the future lease payments must be set forth as an obligation on the balance sheet. “Debt” or “indebtedness” is typically defined to include those obligations arising under capital leases that are required to be capitalized on the balance sheet. Under the new rules, the impact on the typical “debt” definition would be twofold: 1) formerly “off-balance-sheet” operating leases would now be considered to be “debt,” and 2) the capitalized obligations relating to former “capital leases” would change due to the revised method for determining the present value of future lease payments. Therefore, on the day the new rules go into effect, the amount of “debt” would likely increase and the leverage ratio may be violated. Net worth is unlikely to be affected because the right-to-use asset will equal the obligation (assuming no initial direct costs). EBITDA is likely to be higher as explained below.
• EBITDA (EBITDA must equal at least $x at the end of each fiscal period). EBITDA is typically defined as earnings before interest, taxes, depreciation and amortization, and often includes various other adjustments for non-cash and extraordinary items. Under the new accounting rules, rent expense (which reduces consolidated net income) will no longer be recorded. Instead, the lessee will record amortization and interest expense, which typically get added back in the calculation of EBITDA. Therefore, under the new accounting rules, unless rent expense was separately included as an “add-back” in the EBITDA definition ( i.e., “EBITDAR”), EBITDA should be higher than it would have been under the current rules. This will help the lessee-borrower meet a minimum EBITDA financial covenant.
• Fixed Charge or Interest Coverage (EBITDA to Fixed Charges or Interest Expense must equal at least x:1.0). As indicated above, the new accounting rules should result in a higher EBITDA. However, the interest expense (which will now include additional interest expense for operating leases) will also be higher. In addition, the “front-end” loading of interest expense will impact the ratio. For some financing agreements, only cash interest expense is included for purposes of calculating the ratio, in which case, the impact of the new rules may be minimized. For the broader fixed charge coverage ratio, the impact will depend on whether the fixed charge definition includes rental payments (little impact), capital expenditures (see below), principal repayments (potential for impact if the lease obligation is deemed a principal payment) and tax liabilities.
• Capital Expenditures (Capital Expenditures not to exceed $x). “Capital expenditures” are typically defined to include the aggregate of all expenditures of plant, property and equipment, and any other capital asset that is set forth in the consolidated statement of cash flows. Under the new rules, a lessee will be required to present right-of-use assets as if they were tangible assets within property, plant and equipment separately from non-leased assets. Hence, “capital expenditures” should increase under the new rules.

Negative Covenants (Debt; Liens)

Financing agreements typically place restrictions on the incurrence of indebtedness and liens, subject to various carve-outs and “baskets” or dollar thresholds. Reclassifying operating leases as “Debt” or “Indebtedness” may result in a violation of the indebtedness covenant, depending on how broad the carve-outs are and the amount in question. But even if the lessee-borrower is “saved” by a basket/carve-out, this may not be a good result when the original intent of the basket was to allow the lessee-borrower to incur other indebtedness without counting in operating leases. If the lessee-borrower has a significant number of operating leases, it seems likely that reclassifying these leases as indebtedness will result in a breach of the covenant.

The answer is less clear for the liens covenant. Again, the answer will depend on the exact wording of the carve-outs and baskets. A typical carve-out reads as follows:

Borrower shall not ' create, incur, assume or suffer to exist any Lien upon any of its property, whether now owned or hereafter acquired, except for ':

Liens securing Indebtedness of the Borrower or any other Subsidiary incurred pursuant to [the carve-out for purchase money indebtedness and capital leases up to a specified dollar amount] to finance the acquisition of fixed or capital assets, provided that (i) such Liens shall be created substantially simultaneously with the acquisition of such fixed or capital assets, (ii) such Liens do not at any time encumber any property other than the property financed by such Indebtedness or the proceeds thereof and (iii) the amount of Indebtedness secured thereby is not increased;

Let's assume the carve-out fails because the newly reclassified operating leases exceed the specified dollar amount. Has the lessee-borrower violated the covenant?

The answer may depend on whether the lessee-borrower has created or incurred a lien on its property in the case of an operating lease that is now reclassified as a capital lease under the new rules. If the lease is a real property lease, this seems like a strange result. Presumably, the accounting rules change does not result in a change in status of the underlying real property, such that now the lessee-tenant is deemed to be the owner and the landlord is deemed to have a “lien” on the property like a mortgagee. In the equipment leasing world, however, the answer may not be so clear. We are accustomed to thinking of capital leases as the equivalent of secured debt, with the lessor holding a security interest in the leased equipment. But does this make sense where nothing has changed except the accounting treatment? Whether or not the lessor has a security interest or a “true lease” should be governed by ' 1-203 of the Uniform Commercial Code, not the accounting rules. But once the new accounting rules take effect, it is perhaps anyone's guess how a court will apply ' 1-203 in practice.

Conclusion

The new accounting rules, if and when adopted, will require a close look at the GAAP definition and the financial and other covenants contained in the lessee-borrower's financial agreements. It would be wise for counsel to lessees to begin this process now, rather than wait until the lessee finds itself ' unexpectedly ' in default.

Gian-Michele a Marca ([email protected]) is a partner and Barry A. Graynor ([email protected]) is a special counsel in the San Francisco office of Cooley LLP. a Marca represents issuers, private equity firms and banks in various financing and corporate transactions, including bank financings, structured financings, convertible and high-yield bond offerings, equity offerings and mergers, acquisitions and dispositions. Graynor is a member of this newsletter's Board of Editors and specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment.

In August 2010, the FASB and IASB issued a joint exposure draft ' Leases. The exposure draft creates a new accounting model for both lessees and lessors, and eliminates the concept of operating leases. All outstanding leases will be subject to the new lease accounting rules ' there will be no grandfathering of existing leases. The boards are expected to issue a final standard in June 2011, but they have not yet decided on an effective date for the new rules. This article summarizes the new accounting model for lessees and addresses the impact the new model may have on financial and other covenants typically found in financing agreements, where the lessee is the borrower. (The new accounting model for lessors is beyond the scope of this article.)

Summary of the New Accounting Model for Lessees

• Lessees will recognize a right-of-use asset for the lease term and a liability for their obligation to make lease payments. “Off-balance-sheet” leases will no longer exist.
• Except for short-term leases (leases with a term of 12 months or less), the present value of the lease payments will be used in the initial measurement of the obligation to make lease payments, discounted by using the lessee's incremental borrowing rate or the rate the lessor charges the lessee, if it can be readily determined. The right-of-use asset will initially be measured at the same amount plus any recoverable initial direct costs, such as commissions and legal fees.
• If the lease includes renewal options or early termination options, the lessee will need to estimate the probability of occurrence for each possible term in determining the lease term.
• Under an expected outcome approach, the lessee will recognize contingent rentals and residual value guarantees as part of the lease liability.
• Under the new rules, a purchase option will be accounted for only when it is exercised. The exercise price will not be considered a lease payment but part of the cost of acquiring the underlying asset. However, purchase options do factor into the analysis of whether the lease represents a purchase or sale of the underlying asset. If the lease contains a bargain purchase option, it generally would be treated as a purchase and sale under existing GAAP and therefore it would be excluded from the new accounting rules.
• For leases previously classified as operating leases, rent expense will be replaced with amortization expense and interest expense. Amortization of the right-of-use asset will generally be on a straight-line basis. Interest expense will be front-end loaded, like interest on an amortizing mortgage. Therefore, net income could be lower in the first years of the lease under the new accounting rules than it would have been under current operating lease accounting. However, EBITDA would be higher because rental expense is not recorded.
• For leases previously classified as capital leases, the existing capitalized assets and lease obligations, which are based on the greater of the present value of minimum lease payments and fair value, will be replaced with the right-to-use measurement and the present value determinations described above.
• The new rules will require the lessee to periodically reassess the carrying amount of the obligation each reporting period “if facts or circumstances indicate that there would be a significant change in the liability since the previous reporting period.”
• The new rules will result in additional temporary differences for income tax accounting purposes. State and local taxes may also be affected.

Example

Company A enters into an equipment lease. The lease term is noncancelable for five years, with no renewal options. The agreement is for quarterly lease payments of $100,000 per quarter. Company A's incremental borrowing rate is 8%. The agreement does not include a purchase option or a residual value guarantee.

The first step is to estimate the lease payments over the five-year lease term. The lessee estimates that the present value of the lease payments will equal $1,635,143. This is what gets recorded on the balance sheet on day one as the “right-to-use asset” and the corresponding obligation.

Table 1, below, compares the income statement impact in the first year. Under the proposed approach, the expense is front-ended and therefore higher in the first year than what it would have been under current operating lease accounting.

[IMGCAP(1)]

Effect on Financial and Other Covenants

The effect of the new accounting rules on financial and other covenants is manifold. The first thing to check is whether the applicable financing agreement addresses changes in GAAP. If GAAP is “frozen” as of the date of the financing agreement, then the lessee-borrower is protected.

An example of such a provision is as follows (emphasis added):

If at any time any change in GAAP would affect the computation of any financial ratio or requirement set forth in any Loan Document, and either the Borrower or the Required Lenders shall so request, the Administrative Agent, the Lenders and the Loan Parties shall negotiate in good faith to amend such ratio or requirement to preserve the original intent thereof in light of such change in GAAP (subject to the approval of the Required Lenders); provided that, until so amended, (i) such ratio or requirement shall continue to be computed in accordance with GAAP prior to such change therein and (ii) the Borrower shall provide to the Administrative Agent and the Lenders financial statements and other documents required under this Agreement or as reasonably requested hereunder setting forth a reconciliation between calculations of such ratio or requirement made before and after giving effect to such change in GAAP.

Assuming the financing agreement does not have such a provision: What is the impact of the new accounting rules in that situation?

Financial Covenants

The new accounting rules may affect compliance with existing financial covenants. The following are some examples:

• Leverage (Debt to Net Worth or Debt to EBITDA may not exceed x:1.0). As indicated above, the present value of the future lease payments must be set forth as an obligation on the balance sheet. “Debt” or “indebtedness” is typically defined to include those obligations arising under capital leases that are required to be capitalized on the balance sheet. Under the new rules, the impact on the typical “debt” definition would be twofold: 1) formerly “off-balance-sheet” operating leases would now be considered to be “debt,” and 2) the capitalized obligations relating to former “capital leases” would change due to the revised method for determining the present value of future lease payments. Therefore, on the day the new rules go into effect, the amount of “debt” would likely increase and the leverage ratio may be violated. Net worth is unlikely to be affected because the right-to-use asset will equal the obligation (assuming no initial direct costs). EBITDA is likely to be higher as explained below.
• EBITDA (EBITDA must equal at least $x at the end of each fiscal period). EBITDA is typically defined as earnings before interest, taxes, depreciation and amortization, and often includes various other adjustments for non-cash and extraordinary items. Under the new accounting rules, rent expense (which reduces consolidated net income) will no longer be recorded. Instead, the lessee will record amortization and interest expense, which typically get added back in the calculation of EBITDA. Therefore, under the new accounting rules, unless rent expense was separately included as an “add-back” in the EBITDA definition ( i.e., “EBITDAR”), EBITDA should be higher than it would have been under the current rules. This will help the lessee-borrower meet a minimum EBITDA financial covenant.
• Fixed Charge or Interest Coverage (EBITDA to Fixed Charges or Interest Expense must equal at least x:1.0). As indicated above, the new accounting rules should result in a higher EBITDA. However, the interest expense (which will now include additional interest expense for operating leases) will also be higher. In addition, the “front-end” loading of interest expense will impact the ratio. For some financing agreements, only cash interest expense is included for purposes of calculating the ratio, in which case, the impact of the new rules may be minimized. For the broader fixed charge coverage ratio, the impact will depend on whether the fixed charge definition includes rental payments (little impact), capital expenditures (see below), principal repayments (potential for impact if the lease obligation is deemed a principal payment) and tax liabilities.
• Capital Expenditures (Capital Expenditures not to exceed $x). “Capital expenditures” are typically defined to include the aggregate of all expenditures of plant, property and equipment, and any other capital asset that is set forth in the consolidated statement of cash flows. Under the new rules, a lessee will be required to present right-of-use assets as if they were tangible assets within property, plant and equipment separately from non-leased assets. Hence, “capital expenditures” should increase under the new rules.

Negative Covenants (Debt; Liens)

Financing agreements typically place restrictions on the incurrence of indebtedness and liens, subject to various carve-outs and “baskets” or dollar thresholds. Reclassifying operating leases as “Debt” or “Indebtedness” may result in a violation of the indebtedness covenant, depending on how broad the carve-outs are and the amount in question. But even if the lessee-borrower is “saved” by a basket/carve-out, this may not be a good result when the original intent of the basket was to allow the lessee-borrower to incur other indebtedness without counting in operating leases. If the lessee-borrower has a significant number of operating leases, it seems likely that reclassifying these leases as indebtedness will result in a breach of the covenant.

The answer is less clear for the liens covenant. Again, the answer will depend on the exact wording of the carve-outs and baskets. A typical carve-out reads as follows:

Borrower shall not ' create, incur, assume or suffer to exist any Lien upon any of its property, whether now owned or hereafter acquired, except for ':

Liens securing Indebtedness of the Borrower or any other Subsidiary incurred pursuant to [the carve-out for purchase money indebtedness and capital leases up to a specified dollar amount] to finance the acquisition of fixed or capital assets, provided that (i) such Liens shall be created substantially simultaneously with the acquisition of such fixed or capital assets, (ii) such Liens do not at any time encumber any property other than the property financed by such Indebtedness or the proceeds thereof and (iii) the amount of Indebtedness secured thereby is not increased;

Let's assume the carve-out fails because the newly reclassified operating leases exceed the specified dollar amount. Has the lessee-borrower violated the covenant?

The answer may depend on whether the lessee-borrower has created or incurred a lien on its property in the case of an operating lease that is now reclassified as a capital lease under the new rules. If the lease is a real property lease, this seems like a strange result. Presumably, the accounting rules change does not result in a change in status of the underlying real property, such that now the lessee-tenant is deemed to be the owner and the landlord is deemed to have a “lien” on the property like a mortgagee. In the equipment leasing world, however, the answer may not be so clear. We are accustomed to thinking of capital leases as the equivalent of secured debt, with the lessor holding a security interest in the leased equipment. But does this make sense where nothing has changed except the accounting treatment? Whether or not the lessor has a security interest or a “true lease” should be governed by ' 1-203 of the Uniform Commercial Code, not the accounting rules. But once the new accounting rules take effect, it is perhaps anyone's guess how a court will apply ' 1-203 in practice.

Conclusion

The new accounting rules, if and when adopted, will require a close look at the GAAP definition and the financial and other covenants contained in the lessee-borrower's financial agreements. It would be wise for counsel to lessees to begin this process now, rather than wait until the lessee finds itself ' unexpectedly ' in default.

Gian-Michele a Marca ([email protected]) is a partner and Barry A. Graynor ([email protected]) is a special counsel in the San Francisco office of Cooley LLP. a Marca represents issuers, private equity firms and banks in various financing and corporate transactions, including bank financings, structured financings, convertible and high-yield bond offerings, equity offerings and mergers, acquisitions and dispositions. Graynor is a member of this newsletter's Board of Editors and specializes in credit finance and equipment leasing, in particular shipping containers and other transportation equipment.