On February 25, 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02 Leases (Topic 842). Generally, a lessee under a lease with a term of 12 months or more will be required to recognize lease assets and lease liabilities on its balance sheet beginning approximately 2018 (for public companies) and approximately 2020 (for other companies).
This change in the accounting standard creates many potential pitfalls. The danger under the new standard is at least as follows:
The increase in liabilities that a lessee must now recognize on its balance sheet could trigger seemingly unrelated covenants imposing liabilities thresholds or ratios based on liabilities. For example, in the case of ratios based on liabilities, the adoption of the new accounting standard will increase liabilities on the balance sheet (the denominator) and thus lower the ratio.
Lessees should make a point of reviewing their contractual obligations associated with their balance sheet labilities and, if necessary, avoid a contractual foot fault by negotiating with applicable counterparties for appropriate carve-outs.
It is also worth mentioning, that should a lessee decide to delay its adoption of the new accounting standard beyond the time the new guidance becomes effective, any covenant ensuring adherence to GAAP may also be breached.
It is imperative that any lessee take the time to learn and adopt the new accounting standard. In addition, a lessee should ensure adequate safeguards are in place to limit any potential negative reverberations. Following the precautionary steps laid out above could mean the difference between a smooth integration of the new accounting standard and an unintended breach of agreement covenants and subsequent liability.
Ahmed Ammar assisted in the research for this article. Mr. Ammar is an extern in McDonald Hopkins’ Chicago office, and is not a licensed attorney.