Impact of ASC 842 on Debt Covenants and Bank Capital Requirements

Since ASC 842 requires a lessee to recognize a lease liability and corresponding ROU asset for all of its leases (including operating leases), financial statement preparers and users have raised questions about the impact of the new requirements related to operating lease liabilities and ROU assets on an entity’s metrics.

Impact on Debt Covenants

FASB also considered potential issues related to debt covenants and noted the following factors significantly mitigate those potential issues:

1. A significant portion of loan agreements contain “frozen GAAP” or “semi frozen GAAP” clauses such that a change in a lessee’s financial ratios resulting solely from a GAAP accounting change either:
• Will not constitute a default.
• Will require both parties to negotiate in good faith when a technical default (breach of loan covenant) occurs as a result of new GAAP.
2. Banks with whom outreach has been conducted state that they are unlikely to dissolve a good customer relationship by “calling a loan” because of a technical default arising solely from a GAAP accounting change, even if the loan agreement did not have a frozen or semi frozen GAAP provision
3. ASC 842 characterizes operating lease liabilities as operating liabilities, rather than debt. Consequently, those amounts may not affect certain financial ratios that often are used in debt covenants.
4. ASC 842 provides for an extended effective date that should permit many entities’ existing loan agreements to expire before reporting under Topic 842. For those loan agreements that will not expire, do not have frozen or semi frozen GAAP provisions, and have covenants that are affected by additional operating liabilities, the extended effective date provides significant time for entities to modify those agreements.

While the FASB has clearly articulated its view that lease liabilities resulting from operating leases under ASC 842 are intended to be characterized as operating liabilities outside of debt, the Board cannot dictate how banks and other lenders view such amounts. It is unclear whether banks and other lenders will take a consistent approach in evaluating liabilities for debt covenant purposes. Therefore, we encourage preparers and other stakeholders to communicate with these organizations to better understand the effects of ASC 842 on existing and future lending agreements.

Impact on Bank Capital Ratios

Bank regulatory capital (expressed as a ratio of capital to risk-weighted assets or average assets) is the amount of capital that banking regulators (e.g., the FDIC, the Federal Reserve Board, and the OCC) require banks or bank holding companies to hold. Most intangible assets are deducted from regulatory capital, while tangible assets are not. Since ASC 842 does not provide definitive guidance on whether an ROU asset represents a tangible or an intangible asset, stakeholders have asked how bank regulators will treat ROU assets when establishing required capital.

On April 6, 2017, the Basel Committee on Banking Supervision (of which the United States is a member) issued FAQs on how an ROU asset would be treated for regulatory capital purposes. Specifically, the FAQs note that the ROU asset:

•  “[S]hould not be deducted from regulatory capital [since] the underlying asset being leased is a tangible asset.”
• “[S]hould be included in the risk-based capital and leverage [ratio] denominators.”
• “[S]hould be risk-weighted at 100%, [which is] consistent with the risk weight applied historically to owned tangible assets and to a lessee’s leased assets under leases accounted for as [capital] leases” under ASC 840.

Accounting Guidance Referenced:

• Paragraph BC14 of ASU 2016-02
• Deloitte A Roadmap to Applying the New Leasing Standard (2020) 8.1.1