Financial Covenants and the Exposure Draft on Lease Accounting

The International Accounting Standards Board and the US Financial Accounting Standards Board have recently issued Exposure Draft Leases (ED/2010/9) (the “Exposure Draft”) which would significantly change how operating leases are accounted for in a company's financial statements under IFRS and US GAAP. If the Exposure Draft is implemented in its current form, it is likely to impact on financial covenants in facility agreements and other finance documents.

The current situation

Currently, the accounting treatment of a lease under IFRS and US GAAP depends on whether it is classified as a finance lease (also known as a capital lease) or an operating lease. In a nutshell:

• If the lease is classified as a finance or capital lease, the accounting is similar to accounting for an asset purchased with borrowings. The lease obligations are capitalised, resulting in the recognition of a leased asset and a lease liability in the balance sheet, the asset being depreciated and the lease liability being treated as though it were debt service (part repayment of debt, part interest expense) with the debt repayment being shown as a financing cash outflow and the interest expense being shown as either an operating or a financing cash outflow.

• If the lease is not classified as a finance lease, it is treated as an operating lease. Operating leases are off balance sheet in that neither the leased asset nor the lease liability are recognised in the balance sheet. The lease payments are recognised as rent expense in the profit and loss account and treated as an operating cash outflow.

Under the current standards, economically similar transactions can be accounted for very differently because the distinction between operating and finance leases provides opportunities to structure transactions to achieve a particular lease classification.

What are the proposed changes?

Under the Exposure Draft, these sometimes arbitrary classifications would be removed, and all leases (except for leases in respect of intangible assets or non-regenerative resources) would be recognised on the balance sheet. This would have quite dramatic changes for both lessees and lessors:

Lessees:

• As under current finance lease accounting, the initial measurement of the lease liability will be the present value of the lease payments discounted using the lessee’s incremental borrowing rate. The lessee will recognise the obligation to pay the rentals over the longest possible lease term that is more likely than not to occur, taking into account the effect of any options to extend or terminate the lease (based on the weighted probabilities of management expectations). The obligation will also include any contingent rentals or contingent value guarantees.
• The lessee will also recognise a right-of-use asset of the same value, which will be amortised over the term of the lease or the useful life of the underlying asset if shorter.
• The lease payments will be split between repayment of principal and interest and will be classified as financing activities in the statement of cash flows.

Lessors:

There are two methods that can be used, depending upon the terms of the lease and its impact on the lessor, each of which will produce significantly different effects for the lessor:

• Performance obligation approach: this is to be used when the lessor retains significant exposure to the benefits or risks of the leased asset, and the accounting effect is a mirror of the treatment by the lessee described above.

• Partial derecognition approach: this is to be used when the lessor does not retain significant exposure to the benefits or risks of the leased asset. The lessor derecognises the portion of the asset that represents the lessee’s right to use the asset during the term of the lease, and recognises a second, residual (non-financial) asset, being the difference between the lease receivable and the lease payable. A net profit (or loss) is recognised at the commencement of the lease equal to the difference between the present value of the lease payments and the carrying amount of the portion of the underlying asset that is derecognised.

Importantly, leases of investment property, which are measured at fair value in accordance with IAS 40 Investment Property, are currently excluded from the scope of the proposed changes.

The Exposure Draft introduces significant new complexities and considerable operational burden, along with scope for management judgment as to the likely longest possible lease term and the value of any contingent rentals and value guarantees. There is also no de minimis exclusion, so the Exposure Draft would be applicable to every lease, including some very short-term leases (albeit with a different accounting treatment to that described above). Further, as entities are required to produce comparative information, any changes will be retrospective in effect, and there are no “grandfathering” provisions that would take current leases out of the scope of the proposed changes.

What will be the likely impact on facility agreements and finance documents?

1. Changes to financial covenant inputs

The biggest changes will be for entities that have leases currently classified as operating leases. However, even entities with significant finance leases could see some significant changes as the lease obligations (both asset and liability) will reflect the longest possible lease term that is more likely than not to occur and will include the value of any contingent rentals and value guarantees.

There will be an increase in Current Assets, Current Liabilities, Total Net Debt and Borrowings. While both sides of the balance sheet will be increased by the present value of the lease payments, Working Capital will decrease as the Current Liability will also reflect the interest payment for the upcoming financial year.

It is likely that both EBIT and EBITDA will increase as rent expense will be replaced by amortisation and interest expense. Amortisation will be straight-line over the expected course of the lease. Finance Charges will increase as interest will be calculated on a reducing balance method so there will be larger interest payments at the beginning of the lease (which will decline with consequently higher profits as the lease runs its course).
Currently, payments under operating leases are reported as an operating cash outflow whilst, for finance leases, the interest expense can be shown as either an operating or a financing cash outflow. Under the Exposure Draft, the entire lease payment is treated as a financing cash outflow, which will increase Cashflow. Cashflow will also be impacted by EBITDA and Working Capital, as mentioned above.

2. Adverse impact on financial covenant ratios

Some of the standard financial covenants, such as those set out in the LMA Leveraged Facility Agreement, will be affected by the widespread impact of the Exposure Draft on the balance sheet, income statement and cash flow of both lessees and lessors.

Cashflow Cover, Interest Cover and Leverage in leveraged finance transactions (and, as they would be expressed on investment grade transactions, Net Debt to EBITDA and EBITDA to Finance Charges) will be impacted by the proposed changes, because the financial inputs for these covenants will change.

If the effect of the changes on financial covenant calculations is material, this may cause unexpected breaches of the financial covenants, because the ratios will have been set in light of the current lease accounting regime and, therefore, on the basis of expectations which are no longer valid.

3. The proposals will affect facility agreements that are being entered into now

Whilst the Exposure Draft is currently in the consultation phase, it is possible that it could be implemented in time for the financial year ending 31 December 2013. Both borrowers and lenders should therefore consider now the impact which the proposals will have on financial covenants that are intended to operate over the longer term. Sectors which previously relied on extensive off balance sheet funding (such as airlines, hotels, retailers etc) will be significantly affected by the Exposure Draft, as will businesses that have considerable contingent rentals (such as retailers and tenanted pub companies) as the fluctuations of these rentals will impact the balance sheet (with any adjustment passed through the income statement) every financial year. As mentioned above, there are also no “grandfathering” provisions, so leases entered into before the proposals come into effect will be caught by them.

4. Asset financing arrangements may be affected by the proposed changes

Traditionally some lease transactions have been structured in a particular way to achieve a desired accounting treatment. With a consistent accounting treatment for all leases, the accounting reasons to structure transactions falls away, although the structuring of transactions may continue for tax reasons.

Responding to the changes

Finance documents currently treat leases in a manner broadly similar to the current accounting standards – finance leases are treated as Borrowings whilst operating leases are not – and, until the introduction of a new accounting standard, this will continue to be the case. Even after the Exposure Draft has been implemented, this situation will continue for some borrowers since the proposed changes to the accounting treatment of leases will only be applicable to those entities preparing their financial statements under either IFRS or US GAAP (an “Affected Borrower”).

1. Existing Facility Agreements

In respect of existing borrowings, some facility agreements have a “frozen GAAP” provision which provides that all financial information supplied over the term of the borrowing is prepared in accordance with the accounting principles applicable at the date on which the facility agreement was negotiated (“Frozen GAAP”).

Accordingly, Affected Borrowers preparing financial statements under either IFRS or US GAAP need to be aware that, if the Exposure Draft is adopted, they will have to produce audited financial statements reflecting the new lease accounting regime, however, where there is a Frozen GAAP provision they will also have obligations to provide accounting information consistent with Frozen GAAP. As such, an Affected Borrower in these circumstances would be required to provide either a reconciliation between the audited financial statements and those provided to the lenders or such other documentation as may be required which would allow the lenders to evaluate compliance with existing financial covenants on a consistent basis to that historically applied.

In some existing Facility Agreements there are also likely to be provisions requiring the parties to negotiate amendments to the financial covenants in good faith in order to produce covenants which are comparable to those currently in place, but which would reflect the changed inputs resulting from the change to the accounting treatment of leases. However, in these circumstances an Affected Borrower could seek to have the definitions used in certain of the financial covenants amended to carve-out the effect of any changes to the accounting treatment for leases. While the negotiation of amendments to existing covenants may give rise to uncertainties, it clearly avoids the potentially significant administrative and information burden that arises with the Frozen GAAP option which would require an Affected Borrower to reverse out the impact of the new lease accounting regime from their financial statements and supply information to the lenders on a similar basis to that described above.

2. New Facility Agreements

In respect of new facility agreements, both borrowers and lenders should consider now the impact the proposals will have on the financial covenants and try to agree, up-front where appropriate, mechanisms to deal with this. These issues will need to be considered at the term sheet stage, especially if covenant levels are to be agreed at that point. Depending on the borrower and the size and nature of any lease portfolio it has, it may be possible to agree adjustments to the way in which financial covenants will be tested in the future. One option would be to ensure that new facility agreements specify how new accounting standards are to be interpreted, or permit certain leases to be treated (or continue to be treated) as operating leases in order to avoid any unintended consequences or breaches of the financial covenants resulting from changes to the accounting standards.

3. Conclusion

The Exposure Draft is currently in the consultation phase of its development. Whilst it is therefore too early to predict the precise impact of the proposed changes on financing documents, it is imperative that both borrowers and lenders are aware of the proposals. They may well differ in their final form, but it seems certain that existing lease accounting treatment under IFRS and US GAAP will change in the near future. Neither the Loan Market Association nor the Association of Corporate Treasurers are yet to circulate their view of the necessary changes to finance documentation in light of this Exposure Draft, but given the potential impact on borrowers and lenders alike, it is a certainty that both bodies will address this once the Exposure Draft has left the consultation phase.

Financial covenants are included within facility documentation to bring a financial discipline to the borrower, and the impact on financial covenants of a change in lease accounting treatment should not change the fundamental economics of the financing transaction. It may take some time, however, for individual lenders and borrowers to identify the appropriate response in each case to the changes and, more broadly, for the market to reach a new consensus as the level at which financial covenants should be reset to accommodate any changes to the accounting information provided under IFRS or US GAAP.