New accounting standards don't change the underlying economics or cash flows of a business, but the new or re-casted information that becomes available to financial statement users can have real dollar-and-cents repercussions for contracts that are written without considering the impact of new standards. There are many new accounting standards becoming effective over the next three to four years. Two major accounting updates whose implementation are on the horizon and may have significant impacts to your balance sheet and bottom line relate to revenue recognition and leasing. In turn, these changes may trigger contractual terms in lending arrangements, employment contracts, earn-outs, or similar existing contracts.
How Accounting Standards Impact Lending Arrangements
When it comes to lending arrangements, the biggest concern from all the upcoming accounting standards is with the financial covenants included in debt arrangements. These covenants often rely on leverage or EBITDA-based ratios that may be affected by new accounting standards. To gauge the impact new accounting standards could have on your financial covenants, ask yourself the following questions:
- How will the new standards impact my financial statements?
- Will the effect of adoption of a new accounting standard trigger a default?
- Does my lender understand how these standards will impact my financial statements?
- Can I adjust my debt covenants for the impacts of the new standard before they are effective?
- How much will it cost to renegotiate my covenants, or obtain a waiver, if the debt covenants are already set?
The standard debt covenant is a "rolling" covenant. That means if you enter into a five-year term debt agreement with a debt service coverage ratio and a debt to equity ratio today, those ratios are computed based on the U.S. GAAP applicable at each reporting date. If under the new leasing standard there is a violation that would not have been one under the old guidance, you are in default. Once in default, you may seek a waiver from the bank. Getting a waiver from the bank typically takes time to go through loan committee and fees charged for the waiver. Proper preparation and planning can help avoid these costs.
The following are some potential impacts from the new revenue recognition and leasing standards, as well as ways companies can prepare for the potential impact on their debt covenants.
Revenue Recognition Considerations
The adoption of ASC Topic 606, Revenue from Contracts with Customers will make updates to the timing and process for recognizing revenue from contracts. It could impact all sections of the balance sheet and income statement from assets to net income.
Public business entities are slated to adopt the revenue recognition standard for the 2018 calendar year. All other entities will adopt for the 2019 calendar year. There are three items in particular in the standard that could that could negatively impact your covenant compliance:
- Lost revenues
- Material rights
- Adjustments to retained earnings
Entities can use either a full retrospective transition or a modified retrospective approach to adopt the new revenue recognition standard. Those that use a modified retrospective approach to transition their contracts to the new standard might have adjustments to the opening balance sheet from adopting the new standard that could create "lost revenue."
The lost revenue occurs because in some situations revenue recognition is accelerated under ASC Topic 606 compared to the old guidance. When this happens, the old deferred revenue recorded on the balance sheet prior to adoption would have been recognized as revenue in earlier periods under the new standard. In the opening balance sheet, these deferred revenues are removed from the balance sheet and offset directly to retained earnings. The result: those revenues do not flow through the income statement, if not fully offset by other accelerated revenues, making revenues lower in the year of adoption then they previously would have been. This could trigger violations of covenants that rely on ratios based on net income or EBITDA.
A material right is in essence an option. Sometimes a customer is offered the option to purchase a future good or renew a service at a discounted price. Under the new revenue standard, when these options meet certain criteria, revenue is allocated to the option and deferred. Companies that have these options may experience a change in the timing of revenue recognition that could reduce revenues (and income) in the year of adoption and they will record a new "contract liability" (deferred or unearned revenue) on their balance sheet. Covenants based on income or EBTIDA ratios and leverage ratios could all be negatively impacted.
Adjustments to Retained Earnings
The above changes, and others, that may occur as a result of adoption of the revenue recognition standard can result in adjustment to retained earnings at the beginning of the year of adoption. Scenarios may exist where a covenant based on the amount of equity a company has is in compliance on December 31 and upon adoption of the new revenue recognition standard a net debit is recorded to retained earnings resulting in non-compliance for that covenant on January 1, even though there have been no changes in the underlying business.
Leasing Standard Considerations
Lessees must capitalize virtually all leases on their balance sheet in the changes released in ASU 2016-02, Leases (ASC Topic 842). The new standard takes effect for public business entities in the 2019 calendar year and in the 2020 calendar year for all other entities. Capitalizing leases in the balance sheet may have an impact on how lenders compute leverage and debt service coverage ratio-based covenants.
Although the new leasing standard may have some ancillary changes to the income statement, the core issue for lessees is that there will now be a liability on the balance sheet for operating leases. If you have a debt service coverage ratio, debt to equity, or other leverage ratio covenant, does your lender consider operating lease liabilities and related lease expenses to be part of those computations? Is the debt covenant clear in how the ratios should be computed? Lessees should carefully consider these questions prior to the adoption date to ensure their lending agreements are prepared for the change. Leasing standard changes are of particular concern to companies that have significant lease activity, such as retailers and others who have many locations, or businesses dependent on equipment or vehicle leases.
Are you currently in negotiated, long-term debt arrangements? Do you have debt that will be renegotiated or could be renegotiated before you adopt the new accounting standards? If the answer is "yes," the first and best thing you can do is start the process of determining the impact of these new accounting standards on your financial statements and covenants. With that knowledge, you can be prepared to negotiate appropriate covenants that are properly adjusted for the impact of the new accounting standards.
If you don't have the time or resources to estimate the impact of leasing, revenue recognition or other new standards before you need to negotiate debt agreements, you may want to consider some alternatives to the traditional rolling GAAP clauses to minimize the possibility that debt covenants would need to be renegotiated or waived.
One option is a frozen GAAP clause, where the borrower maintains a set of books and records based on the GAAP that was effective at the time the borrower entered the loan covenant. Another option is a "mutual-option-to-freeze" clause that requires financial covenants to be computed under both historical GAAP and newly adopted GAAP. This type of clause allows the lender and borrower to agree to use the old accounting standards for a period of time. There are downsides related to these solutions, including the potential need to keep two sets of books, and costs and challenges with audit requirements.
For More Information
Preparing for the new standards will be difficult. An accounting provider experienced with the standards can help you understand the new standards, estimate their impact, prepare for adoption, and discuss strategies for negotiating arrangements. Please contact Mark Winiarski of MHM's Professional Standards Group or your local service provider to discuss. Mark can be reached at email@example.com.
Published on November 28, 2017