ASC 842 Loan Covenants: Understanding the Impact on Financials

Adopting ASC 842 changes how companies report leases, and these changes can directly affect loan covenants. Recognizing operating lease liabilities and adjusting lease expense classification can lead to higher leverage ratios, different EBITDA, and lower interest coverage ratios.

These shifts may increase the risk of covenant breaches, affect credit ratings, and influence borrowing capacity. In this guide, you’ll learn the main challenges ASC 842 creates for loan covenants and practical ways to stay compliant.

10 ASC 842 Loan Covenant Challenges

Here’s a look at the main ASC 842 loan covenant challenges and how to manage their impact on financials.

1. Increased Leverage Ratios

Recognizing operating lease liabilities on the balance sheet increases reported debt, which can push debt-to-equity and debt-to-assets ratios higher. This can make a company appear more leveraged and may trigger covenant breaches.

Action: Review all leases before year-end and reconcile liabilities to understand their effect on leverage ratios.

2. Risk of Technical Default

Even if a company is operationally healthy, higher reported debt may put it in violation of loan covenants, creating a “technical default.”

Tip: Monitor covenant thresholds regularly and document lease liabilities clearly to avoid surprises.

3. EBITDA-Based Covenant Distortions

Under ASC 842, finance lease expenses are split between amortization and interest, which are excluded from EBITDA. This can make EBITDA appear higher, potentially easing some covenants, though lenders may adjust definitions to neutralize this effect.

Consider: Check your loan agreements for specific EBITDA definitions and reconcile them with ASC 842 treatment.

4. Impact on Interest Coverage Ratios

Interest expense from finance leases may lower interest coverage ratios, signaling reduced ability to meet debt obligations. This can affect borrowing capacity or lender perception.

Action: Recalculate ratios after adopting ASC 842 and consider strategies to maintain healthy coverage.

5. Ambiguities in Loan Agreements

Some agreements may not clearly define “debt” or “EBITDA,” leading to confusion under ASC 842.

Recommendation: Engage lenders early to clarify definitions and agree on the treatment of lease liabilities.

6. Misalignment Between Internal Reporting and Covenant Calculations

Internal accounting adjustments may differ from lender-required calculations, increasing the risk of inadvertent breaches.

Action: Reconcile internal reports with covenant definitions and ensure all calculations reflect ASC 842 correctly.

7. Multi-Year or Complex Lease Portfolios

Companies with many leases or multi-year agreements face a higher risk of miscalculations that can affect covenant compliance.

Consider: Use lease accounting software, such as Black Owl Systems, to consolidate lease data and automate covenant testing.

8. Effects on Credit Ratings

Higher liabilities and altered financial ratios can lead to credit rating adjustments, increasing borrowing costs, or reducing financing options.

Tip: Model different scenarios to understand potential impacts on credit ratings.

9. Inaccurate or Infrequent Covenant Testing

Failing to monitor covenants regularly can result in unexpected breaches, penalties, or audit issues.

Recommendation: Set up a schedule for frequent covenant testing and reporting throughout the year.

10. Compliance and Audit Risks

Errors in covenant reporting can trigger audit findings, disputes with lenders, or regulatory scrutiny.

Action: Maintain thorough documentation and integrate ASC 842 compliance checks into your year-end close process.

Simplify Covenant Compliance with Black Owl Systems

ASC 842 has a significant impact on loan covenants, affecting leverage ratios, EBITDA, and interest coverage metrics. Companies that fail to monitor these changes risk covenant breaches, technical defaults, and even credit rating adjustments. By understanding these challenges, proactively reconciling financial metrics, and engaging with lenders, finance teams can maintain compliance and reduce risk.

Using a robust lease accounting platform, like Black Owl Systems, can simplify tracking lease liabilities, automate covenant testing, and ensure accurate reporting across all leases. Taking these steps early allows companies to navigate ASC 842 changes confidently while protecting relationships with lenders and investors.

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Frequently Asked Questions

1. How does ASC 842 affect loan covenant ratios?

ASC 842 increases reported liabilities by bringing operating leases onto the balance sheet, which can raise leverage ratios and affect compliance with debt-related covenants.

2. Can ASC 842 cause a technical loan default?

Yes. Even financially healthy companies can trigger a technical default if new lease liabilities push them beyond covenant thresholds, especially for leverage and interest coverage ratios.

3. How does ASC 842 impact EBITDA calculations in covenant agreements?

Finance lease expenses shift to amortization and interest, which are excluded from EBITDA. This can increase EBITDA unless lenders adjust the definition to neutralize ASC 842 effects.

4. What should companies do if loan agreements don’t clearly define “debt” or “EBITDA”?

Engage lenders early to clarify definitions and negotiate how lease liabilities should be treated under ASC 842 to avoid compliance ambiguity.

5. How can companies simplify ASC 842 covenant compliance?

Using lease accounting software helps centralize data, automate covenant testing, reduce calculation errors, and maintain accurate reporting for lenders and auditors.