If you are a commercial lender or a borrower you may be aware that the Financial Accounting Standards Board (commonly known as FASB) recently adopted Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842). If you are not aware of that action, we are pleased to bring it to your attention. Why? Because, without attention, this simple-sounding change to generally accepted accounting standards (GAAP) may negatively impact your loan relationships. Fortunately, implementation dates are at least two years away; giving the affected businesses time to assess any impact on their financial statements and to implement appropriate changes.
To simplify a complex pronouncement, the Leases ASU provides that publicly traded companies following GAAP accounting must, commencing with certain fiscal years that start after December 15, 2018, incorporate the amount of their lease assets and liabilities into their financial statements. Under current GAAP rules those types of assets and liabilities are not required to be included in financial statements; they are typically reported in the notes to the financial statements. For other businesses the effective date of the Leases ASU will commence with fiscal years starting after December 15, 2019 and interim periods with fiscal years starting after December 15, 2020.
It is customary for commercial loan documents to contain a number of financial covenants and to require that the borrower prepare and maintain its financial statements in accordance with the provisions of GAAP. The lender will use the GAAP-prepared financial statements to test the borrower’s compliance with the financial covenants. Additionally, traditional representations and warranties include those stating that any financial statement submitted by the borrower to the lender, including any schedules and notes pertaining thereto, is true and complete, and has been prepared in accordance with GAAP. Consequently, if GAAP is incorporated into your lending forms or existing loan document, the calculation of certain important ratios may be affected once the Leases ASU become effective. The consequences of that change can be significant for both borrowers and lenders.
The risks for borrower are probably the greatest if the changes affect them. Because borrowers often must comply with debt limits or net worth ratio maintenance covenants, if the implementation of the Leases ASU adds debt to their financial statements, depending on how such limits and ratios are calculated, they may find that they are unable to meet the limits or covenant ratio after the Leases ASU effective date. Such a failure would constitute an event of default under the loan documents giving the lender the opportunity to enforce its remedies and potentially call the loan.
Lenders probably face a smaller risk from the upcoming change. However, if the change negatively affects their borrower, the lender is then faced with a defaulted borrower and it will have to make plans to address the default. Lenders may not only find that their borrowers fail to meet debt limits and other financial covenants, but if the language of the covenants and representations and warranties in their loan documents is not clear, they may have difficulty in enforcing the obligations, as changed by the Leases ASU, against their borrowers.
Don’t wait for 2018 to roll around. If you are a borrower, contact your accountant and review the impact of the Leases ASU on your financial statements now, while you still have time to react to any potentially negative consequences. If you are a lender, (a) review the language in your loan documents to be sure that your covenants and representations and warranties take into account the upcoming changes; and (b) encourage your borrower to have their financial statements reviewed by their accountants so they understand the impact of the Leases ASU well before the implementation date. After all, as Ben Franklin once observed; “an ounce prevention is worth a pound of cure.”
Tony Salazar is an attorney with the Business and Transactional practice group at Davis, Agnor, Rapaport & Skalny, LLC. For questions about this article or your own banking and financial matters, please do not hesitate to contact Tony at 410.995.5800 or via email.