Corporates often choose to lease long term assets instead of buying them for a number of reasons – there may be tax benefits to leasing the asset and not buying it and leases offer more flexibility in terms of adjusting for technology and capacity needs.
A recently published new IFRS lease standard may have an impact on loan agreements that terminate after 1 January 2019 which are entered into with borrowers which hold a number of leases of movable or immovable assets such as borrowers in the aviation, manufacturing, mining or retail sectors. The new standard will not apply to certain leases such as leases to explore for or use minerals, oil, natural gas or similar non-regenerative resources and leases of biological assets and licenses of intangible assets. A lessee may also elect not to apply certain aspects of the standard to short term leases or leases of assets of low value.
Current lease accounting rules
In terms of IFRS leases are classified as either operating leases, where the lessor transfers only the right to use the asset to the lessee and not ownership, or finance leases, where the lessee may take ownership of the asset. Operating leases are currently not recognised on the balance sheet of the lessee while finance leases are. There is a strong incentive for lessees therefore to structure leases as operating leases and not finance leases so that the related obligations remain off balance sheet. This would give a rosier picture of the lessee’s financial status.
New lease accounting rules
Under the new rules there will be no distinction between operating and finance leases and virtually all qualifying leases which are not currently reflected on the balance sheet of lessees will have to be reflected on their balance sheets.
Impact on loan agreements
Firstly, the new standard will have an impact on leverage and other debt-related ratios (such as debt to equity or debt service cover) used in loan covenants where these ratios are defined with reference to IFRS or the borrower’s financial statements which are drawn up in accordance with IFRS.
A borrower who is a lessee with operating leases may go from meeting the financial covenants to breaching them when the lease accounting rules become effective without any change in its financial commitments. This would occur because the present value of the lease rent under the operating lease would be added to debt on the balance sheet and there will be no corresponding change to the amount of equity.
Secondly, the new lease accounting rules may also result in the borrower being able to incur additional financial indebtedness that it may not have necessarily been permitted to incur previously. Borrowers usually provide an undertaking in loan agreements that they will not incur any additional financial indebtedness. Financial indebtedness is often defined to include any lease liability which would be classified as a finance lease under IFRS. The definition of a finance lease will fall away once the new rules kick in and the borrower will be able to incur financial obligations in the form of a lease that would previously have been categorised as a finance lease.
Provisions to include in post 2019 loan agreements
In order to cater for the new accounting standard, current loan agreements that terminate after 2019 should provide that:
- the accounting rules in effect at the time the loan agreement was entered into will govern definitions used in financial ratios that make reference to accounting standards;
- if there is a change in the accounting standards that would materially affect the computation of financial ratios the parties will negotiate in good faith to amend such ratio; and/or
- specifically, if there is a change that pertains to accounting for leases, no default will occur as a result of such change and the borrower will be obliged to provide the lender with financial statements or other documents required to provide an unaudited reconciliation of such ratio.