Loan Covenant Structuring & Accounting Considerations
Whether you’re in the heat of a deal or the heart of a refinancing, generally accepted accounting principles (GAAP) may be the last thing on your mind when negotiating the terms of what could be a complex debt structure. However, engaging your accounting firm in this process could help you avoid potential issues. Take the time to consider the following matters before the financing agreements are finalized:
- How will the recognition of stock-based compensation, e.g., options or profits-only interest, affect your covenant calculations? Those arrangements may result in the recognition of noncash compensation expense, but such noncash expense wouldn’t be a typical add-back in determining earnings before interest, taxes, depreciation and amortization (EBITDA) unless separately negotiated for inclusion.
- How will future noncash impairment charges for intangibles or goodwill be treated? The best practice we frequently observe is to have such potential future charges be specifically enumerated as an add-back in determining EBITDA.
- How are acquisition-related costs and purchase accounting adjustments treated in measuring covenant compliance? Under current GAAP, nearly all acquisition-related costs are charged to expense as incurred, meaning there’s potential for significant fair value adjustments for acquired inventory; these usually will turn around, i.e., increase expense, in the few months immediately after the transaction.
- Have you considered how future changes in GAAP may affect the measurement of your covenants? For example, if the proposed lease accounting standard takes effect, have you considered how this may affect your covenant calculations? Increasingly, we see GAAP in loan agreements being defined as GAAP as it existed at the date the loan agreement took effect.
- How will the impact of implementing lean or quick-response manufacturing affect your income statement in the short term for GAAP, and how will this be treated for covenant purposes? Typically, as inventory levels fall, you’ll charge certain capitalized costs through the income statement without the benefit of a related recapitalization that exists when inventory levels remain relatively static.
Many loan agreements contain a clause that allows for one-time add-back or noncash charges, but they frequently also contain a cap that’s often exceeded. Although some of these items are hard to model when evaluating the covenants, it’s important to consider these items while you have the ability to negotiate. This can save time and money in the long run, as waivers and amendments can be costly and time-consuming, particularly when having to amend intercreditor agreements and subordinated debt arrangements.
The above examples are just a few ways you can appropriately consider key matters when negotiating loan covenant definitions. For more information on these or related topics, contact your BKD advisor.