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A few thoughts and cautions on the Financial Accounting Standards Board’s New Guideline On Lease Accounting.

The FASB (Financial Accounting Standards Board) makes changes all the time about how you have to prepare your business financial statements in order to comply with generally accepted accounting standards. Most of them are technical and don’t really affect your day-to-day business. We think this New Guideline for Leases is a different kind of animal and we’re pretty sure it will prove to be very punitive for many of the unprepared.

Before this new guideline came out, businesses had a certain latitude on how they accounted for just about any equipment financing that was documented as a Lease. Now there is no choice and unless a lease has very specific structure characteristics (which most do not), the new guideline requires that you account for it as a loan and not a lease. This is true not only for any new financing but in most cases, you will have to change how you report your existing equipment obligations as well.  

The Bad News

Your financial statements will reflect more debt than they did previously and that is not good.  As your debt increases, and it most likely will, your Debt to Worth ratio will change. This ratio is one of the most common barometers used by banks and commercial lenders in determining which credit requests they will approve and which they will decline. This ratio is also a factor in determining what rate you will pay for a commercial loan. So, not only does more debt on your balance sheet make it harder to qualify for a loan but also it likely will be a lot more expensive to borrow if you do qualify.

The Really Bad News

Your Debt To Worth ratio changes it is possible that your new ratio will throw you into a technical default of your existing borrowing covenants. This means your bank or commercial lender has the right to call your loan. Remember in 2008, when the real estate values plummeted across the country? Numerous small business owners that used home equity lines to finance their businesses were caught off guard and were called upon to pay down or pay off their loans. Too many people lost their homes because the new loan to value ratio created a technical default. It could happen again and if it does your options will be to pay off the loan, negotiate new terms of borrowing (read higher rates), or inject new capital into your business to increase your ratio.

Be smart, have your accountant prepare a forward-looking financial statement using the new guidelines and calculate your Debt To Worth ratio. Then review your loan and line documents. If you’re out of compliance or will become out of compliance, contact your bank right now and get ahead of this.   

To get a better understanding of this new standard please visit the Financial Accounting Standards Board website here.

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