AAF NEWS FLASH

October 21, 2010

As a valued friend of AAF, we are committed to keeping you aware of the latest updates. As early as 2011, recently proposed lease accounting rule changes may significantly affect your financial statements. If adopted, these changes will add a significant amount of debt to the balance sheet of most entities and, most likely, negatively impact the calculation of common financial ratios. As a result, this proposed change could have a material effect on financial loan covenant compliance.

How does this affect your company?

This proposed change is expected to impact all entities with operating leases. The most significant effect will be for those entities that have a considerable number of operating leases and especially those with long term leases.

Under the proposed accounting model, lessees will recognize an asset on their balance sheet which represents the “right to use” leased item. An offsetting liability will be presented as debt on the balance sheet and measured using discounted cash flow techniques. The asset will be depreciated and interest expense recorded on the debt in lieu of rent expense. Operating leases signed prior to the implementation of the new rules are expected to be reclassified as capital leases that must be reflected on the balance sheet.

In the example below, assume John Company and Mary Company are identical companies (same cash flow, capital expenditures, operating leases, etc.) with the exception of balance sheet leverage. Also assume it is common practice for a lender to provide a maximum balance sheet leverage covenant to John Company of 2.00 while Mary Company may have a covenant of 3.25. Now, assume that once the proposed lease accounting change is implemented, both companies are required to record a $2 million liability. In both instances, upon adoption of the lease accounting change, the companies do not meet the required financial loan covenants and are in default of their loan agreement, even though there has been no economic change in either company’s financial position.

	Pre-Proposed Lease Change		After-Proposed Lease Change
	John Company	Mary Company	John Company	Mary Company
Total Assets	5,000,000	5,000,000	7,000,000	7,000,000
Total Liabilities	3,000,000	3,500,000	5,000,000	5,500,000
Equity	2,000,000	1,500,000	2,000,000	1,500,000
Balance Sheet Leverage	1.50	2.33	2.50	3.66
Maximum Balance Sheet Leverage	2.00	3.25	2.00	3.25
Covenant Met?	Yes	Yes	No	No

What can you do right now?

In order to estimate how this change may affect your business, summarize all of your operating leases and consider the impact they will have on your financial statements. If the impact on your balance sheet is potentially significant, you may want to:

• Calculate your loan covenant ratios using your balance sheet as adjusted for these accounting changes
• Amend existing loan agreements so the loan covenants exclude any impact from lease accounting rule changes
• Modify or change existing loan covenant definitions and calculations to specifically exclude capital leases
• Look at the impact of these changes to your expenses and the subsequent impact on any contracts, compensation agreements, etc.
• Consider the best method for acquiring new assets and facilities – is it better to purchase or lease?
• Estimate the effect of this change on the timing of your expenses and re-forecast your financial results to see the full impact of the change
  
  If you have any questions or need further assistance with this, please contact a member of our team. We are here to help!
  

Sincerely,

Your Friends at Alexander, Aronson, Finning & Co.

P.S. If you have business associates and friends who might be interested in this topic, please feel free to share this with them. We do appreciate referrals.

 

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