ASC 842 – Lease Accounting Standard Impact on First Quarter Debt Covenants

ASC 842, the new lease accounting standard, is effective for private companies for periods beginning after December 15, 2021. This new standard brings all leases on to the balance sheet by creating right of use (ROU) assets and liabilities. Under ASC 842, the ROU asset is classified as noncurrent, and the lease obligation is classified as both current and noncurrent. Additionally, total liabilities increase with no changes to equity.

Under ASC 842, these changes to the balance sheet may impact financial statement covenants commonly seen in private companies. For example, the current ratio is impacted due to the ROU asset being classified as noncurrent, while a portion of the lease liability is classified as current, causing a decrease in the ratio. The debt-to-net worth ratio and the debt-service coverage ratio may be impacted depending on how the word “debt” is defined in financing agreements with banks and other lenders. It is important for private companies to consider the impact of the new lease standard in the first quarter of 2022 to determine the impact of covenant compliance and avoid having to amend covenants in future periods after implementation.