Effects of Adopting Private Company Reporting Alternatives on Debt Covenants
Author: Matt Glover
In response to years of deliberations and discussion on differences in the accounting needs between public and private companies, the Financial Accounting Standards Board (FASB) formed the Private Company Council (PCC) in 2012 to advise whether and when alternatives within U.S. generally accepted accounting principles (GAAP) are warranted for private companies. One of the first changes resulting from recommendations of the PCC was the 2014 issuance of Accounting Standards Update (ASU) 2014-02, Intangibles – Goodwill and Other (Topic 350): Accounting for Goodwill. This new ASU provided an alternative for private companies to amortize goodwill.
Adoption Requires Looking Ahead
Initial responses were positive, as this guidance potentially reduced the frequency of the time-consuming—and often costly—annual goodwill impairment testing required under the non-PCC standard. However, as entities began to consider whether adoption was in their best interest, there were considerations to evaluate before adopting the new alternative. Even if companies did not meet the definition of a public business entity, management had to consider the likelihood the company might meet that definition in the future. Reversing the election in the future could be very difficult or even impossible.
Management of companies eligible to adopt the new alternative should evaluate the potential effects on financial statements, debt covenants and financial statement users.
If the company chooses to adopt the new alternative, goodwill is amortized over 10 years—or a shorter period if the company can demonstrate a shorter useful life is more appropriate. In addition to the aforementioned benefits, adoption will increase amortization expense reducing both net income and equity in the company’s financial statements.
The impact on compliance with company debt covenants also must be considered. Debt covenants typically are categorized in two groups: capital and performance covenants. Capital covenants relate to the company’s level of equity or debt and seek to maintain sufficient capital in the company. Examples include debt-to-equity, loan-to-value, debt-to-tangible net worth and leverage; they rely mainly on balance sheet information. Performance covenants serve as more timely indicators of economic performance and rely more on income statement information. Examples include earnings before interest, taxes, depreciation and amortization (EBITDA) ratios, interest coverage, fixed charge coverage or debt-to-cash flow.
In today’s lending environment, many performance covenants are based on EBITDA or cash flow ratios, which are not affected by amortization expense. Also, as the new accounting alternative will negatively affect equity, some capital covenants will be affected by the new alternative. However, many lenders have moved to tangible net worth as the measure used in their covenants, meaning adoption of the accounting alternative will not affect those covenants.
Before adopting the accounting alternative, companies should discuss these matters with their creditors and whether adoption will negatively affect any existing debt covenants. In addition, management should seek input from financial statement users to determine whether adoption will negatively impact the company.
For further information, contact your BKD advisor.