Last summer, the Financial Accounting Standards Board (FASB) issued proposed new standards for lease accounting that, if and when they are adopted, will result in major changes in the way that virtually all leases are accounted for under U.S. generally accepted accounting principles (U.S. GAAP).

These changes will have a significant impact on the financial statements sub-mitted by many of your business borrowers. In particular, they will result in the addition of long-term payment obligations to borrowers’ balance sheets, which would likely impact their ability to meet debt service coverage and financial leverage ratios and other covenants included in small business loan agreements.

A Little Background
U.S. GAAP has always distinguished between two different types of leases: capital leases, in which leased assets are recorded on the books and depreciated similarly to debt, and operating leases, which are off-balance-sheet, expensed and deducted from net income.

As the movement toward a convergence of U.S. GAAP and International Financial Reporting Standards (IFRS) has gained steam over the past few years, the issue of lease accounting has been at the forefront. IFRS does not distinguish between capital and operating leases, but rather treats all leases from an accounting standpoint in the same way that U.S. GAAP treats capital leases, leaving them on the books to be depreciated.

Advocates of the proposed new lease accounting standards believe that these standards more faithfully represent the economic reality of leasing activities, and that they reflect more concrete accounting principles as opposed to less-specific “bright line rules.”

In July, FASB and the International Accounting Standards Board (IASB) announced that they would reissue the proposed new lease accounting standards for public comment before the end of this year. Some experts believe that this means the new standards could officially be issued in early 2012 and implemented a year or two after that.

From the Banker’s Perspective
What does all this mean from your perspective as a small business lender? The requirement to record small business leases as liabilities — and, as such, payment obligations — on the balance sheet will result in substantially more leverage being added to their balance sheets. In the balance sheet equation, Assets = Liabilities + Owners Equity, the present value of the right to occupy the space during the term of the lease would be booked as the asset to offset the lease liability.

You are likely to see balance sheets with additional long-term obligations (referred to as “obligations under leases”) that are similar to long-term debt. This will affect a borrower’s ability to meet loan covenants and agreements. In particular, the proposed changes in lease accounting will impact borrowers’ debt service coverage and financial leverage ratios. The accounting treatment of operating leases could also affect a banker’s calculation of tangible net worth.

As banks adopt more conservative credit standards and debt service coverage ratios are increased, adding lease payments to the numerator will make it more difficult for companies to comply.

Meanwhile, from a small business borrower’s viewpoint, the new lease accounting standards will force them to view leases from a broader perspective — in view of all of their other debt obligations, not just as an off-balance-sheet transaction.

The Bottom Line
Borrowers that would have qualified for financing before the new lease accounting standards may no longer qualify due to the increased leverage added to their balance sheets and its impact on the calculation of debt service coverage. And borrowers that complied with loan covenants before the new standards may no longer comply for the same reason.

While implementation of the proposed new lease accounting standards may still be two or more years away, now is the time to begin preparing for their potential impact on your borrowers, both current and future. It will be especially important to scrutinize borrowers whose financial statements are not audited or compiled by a CPA.

For more details on how proposed new standards for lease accounting may impact your borrowers, please contact our office. We’d be glad to discuss your specific situation with you.