The lease that breaks your covenant

A business with a facility takes a five-year lease on a second site. Nothing about it feels like borrowing. There is no lender, no application, no security, and the rent is an operating cost like the electricity. Six months later the annual accounts land with the bank and the covenant test comes back tighter than anyone expected.

The lease did it. Under the accounting standards that govern lease reporting, a lease of any length and substance is recognised on the balance sheet: an asset representing your right to use the premises, and a liability representing everything you have committed to pay. The liability looks like debt because, in substance, that is what it is.

Whether your business has to report this way is a question for your accountant, and for many small businesses the answer is no. But the covenant in your facility agreement may define debt by reference to the accounting standards regardless, and that is worth reading before you sign anything with a five-year term on it.

What lands on the balance sheet

The liability is the present value of what you have committed to pay, discounted at the rate you would pay to borrow the same money over the same period. It is not the sum of the rent. Committing to $250,000 of rent over five years does not add $250,000 of debt, because money paid in year five is worth less than money paid now.

Two exclusions matter and they are the reason most small businesses see less of this than they fear. Leases of twelve months or less stay off the balance sheet, and so do leases of low-value items, which is generally read as assets worth around $10,000 or less when new. A photocopier is out. A five-year lease on a warehouse is very much in.

Why year one costs more than the rent

This is the part that catches people, and it has nothing to do with cash. Once a lease is on the balance sheet the rent stops being a single expense. It splits into two: depreciation of the right-of-use asset, spread evenly, and interest on the liability, which is highest at the start because the balance is highest at the start.

Take a five-year lease at $50,000 a year, paid annually in arrears, with an incremental borrowing rate of 7%.

So a business that signs this lease reports $205,010 of additional debt it did not have, and a first-year profit $5,353 lower than the cash suggests. Both movements push in the same direction on the ratios, and neither reflects anything having gone wrong.

Which covenants feel it

The other timing problem

There is a second effect worth knowing about, which is that this treatment front-loads cost across the whole life of the lease, not just year one. Early years carry more interest and therefore more expense; later years carry less. A business that signs several leases in the same year takes the front-loaded hit on all of them at once.

That is a genuine reason to stagger commitments where you have the choice, and a genuine reason to raise a large lease with your lender before signing rather than after.

What to actually do

• Read how your facility agreement defines debt. If it refers to the accounting standards, or to liabilities as reported in your audited or reviewed accounts, leases are likely in scope. If it names specific facilities, they may not be.
• Ask your accountant whether your business reports this way at all, before assuming any of this applies to you. Many small businesses do not, and for them this is a question about the covenant wording rather than about the accounts.
• Raise a significant lease with your lender before you sign. A covenant breach discussed in advance is a conversation. The same breach discovered in your annual accounts is a default, and the difference is entirely about timing.
• Consider the term. A lease under twelve months stays off balance sheet, which sometimes makes a short lease with an option genuinely cheaper in covenant terms than the same premises on a five-year commitment.
• Check your headroom before committing, not after. If you are already close to a test, work out what the lease does to it while you can still negotiate the term.

The line this article does not cross

Everything above describes a mechanism on a stated hypothetical. Whether your business is required to apply these standards, what discount rate is appropriate to your circumstances, and how a specific lease should be recognised in your accounts are questions for your accountant, and they are outside what this firm does.

What is squarely in scope is the consequence: knowing that a lease can move a covenant, and knowing to check before you sign rather than after your accounts are lodged.