How to Prepare Debt Covenants for Recent Changes to the Accounting for Debt Issuance Costs

Sometimes a revision to an accounting standard will have an impact that takes a while to become apparent to the financial reporting community. Accounting standard changes tend to affect financial statements, and so changes to the financial statements may affect the business operations that rely on them, such as lending arrangements.

Much has been said already about how the major changes to revenue recognition released under ASC Topic 606 and the changes to leasing affect the financial ratios that inform debt covenants. With the focus on revenue recognition and leasing, however, other accounting standard changes that could affect financial reporting may have been overlooked. Such may be the case with ASU No. 2015-03, Interest – Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs (ASU 2015-03).

What has Changed with Presentation of Debt Issuance Cost?

The Financial Accounting Standards Board (FASB) issued ASU 2015-03 to remove inconsistencies with the treatment of debt issuance costs. Prior to the issuance of ASU 2015-03, debt discounts and premiums were presented on the balance sheet differently than debt issuance costs. With the issuance of ASU 2015-03, the FASB required that debt issuance costs be presented as a direct deduction of the principal debt balance. In other words, the new standard clarifies that debt issuance costs can no longer be treated as a prepaid asset. They must be presented in the same manner as debt discounts and premiums. It went into effect for fiscal years beginning after Dec. 15, 2015 (generally 2016). Private companies implemented for interim fiscal periods after Dec. 15, 2016 (generally 2017). Entities retroactively adopted the standard and adjusted financial statements to account for the effects of adopting the new standard.

Debt Issuance Cost Changes’ Impact on Loan Covenants

While ASU 2015-03 does not change the amount of debt issuance costs recognized on the balance sheet, the new presentation requirements have the potential to change the amount of debt presented on an entity’s balance sheet. Many companies had debt issuance cost that was a prepaid asset, so the change to presenting debt issuance costs as a direct deduction of the principal debt balance reduces the amount of debt and the amount of assets, with the potential to affect the computation of the related debt covenant ratios.

It is extremely common for financial covenants related to debt to contain a covenant that relies on a U.S. Generally Accepted Accounting Principles (GAAP)-compliant balance sheet. This so-called “rolling” debt covenant requires debt agreement ratios to be computed based on the U.S. GAAP in effect at each reporting date. Companies will need to closely examine their ratios to determine how they may be affected by the standard, particularly if they have debt ratios near the prescribed threshold specified in their financial covenants. Entities should also examine their agreement terms. Some agreements may include language that would allow lending arrangements to be amended should GAAP affect debt covenant ratios, but others may not, which could put the borrower at risk of being in default. If a borrower goes into default, it would need a waiver from the lender and go back through the time and expense of working with the loan committee.

Considering experiences from this recent change, and the upcoming significant financial reporting changes (revenue recognition, leasing and financial instruments), borrowers may be able to avoid the hassle of renegotiating lending arrangements if they prepare projections of the impact of all the changing accounting standards to gauge just how the changes affect their financial covenant calculations and work with their lender to address these changes as debt agreements are renewed or refinanced.

For More Information

An experienced accounting professional may be able to assist your organization in understanding the full ramifications of accounting standard changes. For more information, please contact James Comito of MHM’s Professional Standards Group.

Published on July 31, 2018