You are the chief financial officer for RAM Solutions, a small but rapidly growing retail computer hardware chain. You are trying to figure out how to finance the new buildings that are scheduled to be purchased this year. The difficulty is that RAM has an existing loan with Commercial Security Bank (CSB) that requires RAM to maintain an interest coverage ratio (Operating income/Interest expense) of 2.0 or greater. Forecasts for next year are as follows:
Forecasted operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000,000
Forecasted interest expense (assuming no new borrowing) . . . . . . . . . . . . . . 7,000,000
Cost of purchasing new buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000,000
If you borrow the $50 million needed to finance the new buildings, the increased interest expense will cause you to be in violation of the interest coverage constraint.
The controller has suggested an accounting solution to this dilemma: lease the new buildings, carefully constructing the lease agreements so that the leases will be accounted for as operating leases. The leasing arrangements will be economically similar to purchase of the buildings with borrowed money, but the annual payments will be reported as rent expense instead of interest expense. Accordingly, the interest coverage loan covenant will be completely sidestepped.
You personally negotiated the loan with Commercial Security Bank, and you know that the intent of the loan covenant was to prevent RAM from incurring large fixed obligations that might endanger the repayment of the CSB loan. Operating lease payments are fixed obligations, just like interest payments, and you are uneasy about using this accounting trick to get around the loan covenant. However, there does not seem to be any other solution. What should you do?