The Impact of the Lease Standard Post-Implementation: Navigating the New Accounting Landscape

By Noorus S. Khan, CPA, Smolin, Lupin & Co., LLC – August 28, 2023

The accounting landscape has been transformed due to the introduction of the new lease standard, known as ASC 842. This standard has revolutionized the way organizations account for leases, affecting financial reporting, compliance and business operations. As organizations adapt to the post-implementation phase, it is crucial to assess the impacts.

Enhanced Financial Reporting and Transparency

The new standard was implemented to bring transparency and consistency to lease accounting practices. Under this standard, lessees are required to recognize most leases on their balance sheets as right-of-use (ROU) assets and corresponding lease liabilities. This replaces the previous distinction between operating and finance leases, which was often criticized for enabling off-balance-sheet financing. This increased transparency enables stakeholders, including investors and analysts, to make better-informed decisions based on a clearer understanding of a company's lease obligations and their impact on its financial health.

Impact on Financial Ratios and KPIs

The implementation of the lease standard can impact financial ratios and key performance indicators (KPIs). As leases are recorded as both assets and liabilities on balance sheets, metrics such as debt ratios, return on assets (ROA) and EBITDA (earnings before interest, taxes, depreciation and amortization) may be affected. Organizations must be aware of these changes and communicate them effectively to stakeholders, ensuring they understand the impact of the lease standard on financial analysis and interpretation.

Impact on Bank Covenants

Bank covenants are a crucial aspect of loan agreements between borrowers and lenders. These covenants are financial performance measures that borrowers must adhere to in order to maintain compliance with their loan terms. They are designed to protect lenders by ensuring that borrowers maintain financial health throughout the life of the loan.

With the adoption of ASC 842, requiring the inclusion of lease liabilities on the balance sheet triggered changes in financial ratios. Some of these ratios included:

Leverage ratios: Leverage ratios, such as debt-to-equity and debt-to-assets, are used to assess a company's risk and solvency. The inclusion of lease liabilities on the balance sheet may lead to an increase in total liabilities, potentially pushing these ratios beyond the allowable limits set by the bank covenants.
Interest coverage ratios: These ratios measure a company's ability to cover its interest payments with its operating income. Including lease interest expenses in the calculation may reduce the interest coverage ratio, potentially leading to covenant violations if the ratio falls below the specified threshold.
EBITDA: The recognition of lease expenses on the income statement can impact EBITDA, a common measure of operating performance. Since EBITDA is often used as a basis for covenant calculations, any reduction in EBITDA due to lease expenses could affect covenant compliance.

Negotiating New Covenant Terms

Companies that are significantly impacted by the new lease standard and subsequent covenant breaches may need to negotiate with their lenders to amend covenant terms. This might involve adjusting covenant thresholds or introducing new metrics that better reflect the company's financial health under the new lease accounting rules.

Increased Compliance and Audit Scrutiny

With the lease standard becoming more complex, compliance and audit scrutiny have intensified. Organizations must ensure they have proper internal controls, processes and documentation to support lease accounting decisions. Lease audits play a critical role in verifying compliance with lease standards and identifying any potential errors or inconsistencies. As auditors focus on lease accounting practices, organizations should proactively prepare for lease audits by maintaining accurate and up-to-date lease records, documentation and supporting evidence.

The post-implementation impacts of the lease standard has transformed lease accounting practices and significantly influenced financial reporting, decision-making and risk management. The increased transparency and visibility of leases on balance sheets provide stakeholders with a clearer understanding of an organization's financial position. However, adapting to the new accounting landscape requires organizations to implement robust lease administration practices, ensure compliance and effectively communicate the impact of the lease standard on financial ratios and KPIs. By embracing these changes and implementing effective lease management strategies, businesses can navigate the post-implementation impacts of the lease standard successfully and leverage the benefits of enhanced financial reporting and informed decision-making.