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It’s Almost Year-End. Do You Know Where Your Covenants Are?

It’s Almost Year-End. Do You Know Where Your Covenants Are?

Oct 30, 2017

One of the most crucial and overlooked parts of signing a debt agreement appears in that small paragraph entitled “Covenants.” It is essential to your organization to monitor your covenants throughout the year so you are not surprised come year-end. Covenants come in many ways, shapes, and forms. You likely have financial covenants, nonfinancial covenants, affirmative covenants, and negative covenants. It is important that you manage your covenants before they manage you.

Failure to meet covenants could result in varying degrees of action the lender can take, ranging from waiving the violations to more serious consequences. Specifically, covenant violations may give the lender the right to suspend further lending, call the debt, or seize assets that were collateralized under the agreement.

Okay, What Can I Do Now?

The keys to knowing where you stand with your covenants are having a full understanding of their requirements and incorporating the calculation of these covenants into your budgeting and monthly financial statement closing process. Taking these simple, proactive steps and incorporating them into your monthly routine will greatly reduce the stress and anxiety of meeting covenants at year-end.

In addition, be sure to consider how your monthly statements compare to your year-end statements. In other words, do you typically have large year-end adjustments to update estimates, accruals, or any other trial balance accounts that might significantly impact your covenant calculation? If so, you may want to factor these adjustments into your interim calculations to avoid any surprises at year-end.

Potential GAAP Changes and How They Could Impact Covenants

For a longer-term analysis, keeping an open line of communication with your lender and CPA is more important than ever. There are three changes in U.S. generally accepted accounting principles (GAAP) that will have a large impact on your covenants. Even though the three changes noted below will not be in effect for a couple of years, it is important to reach out to your financial lender and CPA now to start talking about how these new standards could impact your covenants and to determine whether those covenants should be rewritten to incorporate the effects of these GAAP changes.

The most recent change in GAAP occurred on September 13, 2017, when the FASB agreed on an update to get rid of the current complex debt classification rules and make the distinctions between short-term and long-term debt more clearly linked to the true reflection of the economics at the balance sheet date. When the guidance becomes effective (fiscal years beginning after December 15, 2019, for public companies and a year later for private companies), companies will no longer be able to change the classification of the debt based on a refinance after the balance sheet date but prior to the audit report date. Rather, the debt classification will be determined solely by the facts and circumstances that existed at the balance sheet date. There is, however, an exception that still allows organizations to obtain covenant waivers if certain conditions apply.

The second change is not necessarily new, and it is quickly becoming one of the most talked-about standards in recent GAAP history. Yes, we’re talking about the new revenue recognition standard, ASC 606, which will likely have a significant impact on the timing and amount of revenue recognized in your financial statements. As you prepare your organization for the impact of the changes in ASC 606, it is important to analyze the impact they will have on key performance metrics that are commonly found in financial covenants.

The third change is the looming lease accounting standard, ASU 2016-02, which will require many organizations to capitalize leases that had historically been considered operating leases and thus were not reflected on the balance sheet. With these impending changes to your assets and liabilities, there is potential for significant changes to various financial covenants.

Conclusion

As you can see, there are some major changes to GAAP that are coming and will likely directly impact your covenant calculations. It is imperative to your organization that you fully understand the covenants you have in place and are actively managing those covenants throughout the year and for the years to come. If you are like most accountants, you want to avoid surprises. Managing your covenants is a perfect example of how proactive behavior can help you and your organization avoid any negative surprises.

By Nate Bartz
Nate is a Senior Accountant in our Wausau, Wisconsin office and primarily serves the manufacturing, distribution, and commercial industries while also working in the employee benefit practice. He also has significant corporate tax experience serving privately-held companies. Contact Nate at 715.843.7499 or e-mail him at nbartz@wipfli.com.