Many not-for-profit entities (NFPs) are required to meet financial covenants as conditions of debt arrangements and credit agreements. Financial covenants are legally binding and, if not met, they can trigger default or other legal action.
FASB ASC Topic 842 Leases, requires lessees to recognize assets and liabilities for substantially all leases. Under the new guidance, effective for fiscal years beginning after December 15, 2021 for nonpublic NFPs and for fiscal years beginning after December 15, 2019 for public NFPs, operating leases, which have typically been off-balance sheet transactions, will be recorded as an asset and a liability in most cases. NFPs with significant operating leases will experience an immediate increase in assets and liabilities on their statements of financial position upon adoption of ASC 842. As a result, some NFPs may be in violation of financial covenants.
NFPs should work with their lenders to understand the effects of the new lease accounting standard. Lenders recognize that adding operating leases to the statement of financial position does not change an organization’s economic condition or ability to meet its obligations as they come due. Accordingly, lenders are unlikely to discontinue a good customer relationship due to a technical default.
NFPs should also consider modifying existing debt and loan agreements to avoid unnecessary violations of financial covenants by including a “frozen GAAP” or “semi-frozen GAAP” clause. A “frozen GAAP” clause provides that changes in financial ratios resulting from changes in GAAP will not result in a violation of financial covenants. A “semi-frozen GAAP” clause requires the parties to renegotiate the loan covenant if the change in GAAP alters financial ratios.
After adopting Topic 842, NFPs may wish to modify covenants going forward and continue to include frozen GAAP or semi-frozen GAAP clauses as they enter into new loan agreements. This will add flexibility that may be needed to adapt to future reporting requirements.
For additional information on the Leases standard, check out these resources: