The Financial Accounting Standards Board recently implemented two new rules under GAAP that may affect credit agreements, including the way a company calculates EBITDA and total liabilities when determining compliance with financial covenants.
Although these new rules had been outstanding for a while, they are just starting to take full effect with respect to companies. For private companies, ASC 606 takes effect for fiscal years beginning after December 15, 2018, and ASC 842 takes effect for fiscal years beginning after December 15, 2019. For public companies, ASC 606 took effect for fiscal years beginning after December 15, 2017, and ASC 842 takes effect for fiscal years beginning after December 15, 2018. One should understand how credit agreements may be implicated by these changes.
The New Revenue Recognition Standard (ASC 606)
The first change in standards is ASC 606, which is a new revenue recognition rule that standardizes the way certain companies recognize revenue. Companies that fall under this new rule are those that enter into contracts with customers to transfer goods or services.
Prior to ASC 606, each industry had its own guidance for recognizing revenue, often with the goal of minimizing volatility. In general, under the new rule, revenue must be recognized when a performance obligation under a contract is satisfied.
The implementation of the revenue recognition standard may have more of an impact on some companies than others – likely those that experience more volatility in monthly and quarterly revenue and those with more long-term contracts and deferred revenue. For these companies, the new rule could impact the financial covenants in credit agreements because of the effect a change in revenue may have on the calculation of EBITDA, net income, total assets and excess cash flow.
Before even looking at such impact, though, a company should determine whether the definition of GAAP, as defined in its credit agreement, is fixed or frozen as of the closing date. If it is frozen, then ASC 606 will likely not apply unless the change triggers a renegotiation right.
The New Lease Accounting Standard (ASC 842)
The FASB also implemented a new lease accounting rule, ASC 842.
Historically, only capital leases were recorded on a company’s balance sheet, while operating leases were excluded. ASC 842 requires that all leases other than short-term leases (less than 12 months in duration) are recorded on the balance sheet with a right-of-use asset as an offsetting liability.
As a result, many more lease liabilities will be recorded on the balance sheet than in prior period. This affects covenants in credit documentation in various ways including by increasing the amount of debt for which basket capacity is needed (if “Indebtedness” is defined as including liabilities shown on the balance sheet) and by making financial covenants (such as leverage ratios) much harder to comply with given the increased amount of total liabilities.
This new lease accounting rule has been highly anticipated in the market, and, as a result, to deal with the potential for increased liabilities it is becoming more typical to include language that effectively disregards ASC 842 for the purposes of all financial definitions and calculations in credit agreements, while recognizing that the rule still applies to financial statements. An example of such language is set forth below:
“All obligations of any Person that are or would have been treated as operating leases for purposes of GAAP prior to the issuance by the FASB on February 25, 2016 of an Accounting Standards Update (the “ASU”) shall continue to be accounted for as operating leases for purposes of all financial definitions and calculations for purposes of this Agreement (whether or not such operating lease obligations were in effect on such date), notwithstanding the fact that such obligations are required in accordance with the ASU (on a prospective or retroactive basis or otherwise) to be treated as Capitalized Lease Obligations in the financial statements.”
The new revenue recognition standard in ASC 606 could have a significant impact on the ability of some companies to comply with their financial covenants and may require an amendment to their credit agreements to give relief due to the rule changes.
The effect of the lease accounting rule has been mitigated somewhat by specifically excluding application of the new rule. However, in each case, it is very important for borrowers and lenders to consider the impact of these changes on their covenants and credit documentation.