Debt Covenants Changing?

Will debt covenants of some U.S. companies change in the near future? I think so.

Two dynamics will drive these changes.

  1. The lease accounting standard
  2. Use of the AICPA Financial Reporting Framework for Small- to Medium-Sized Entities (FRF for SME) – a new “other comprehensive basis of accounting”

The lease standard has not, as of yet, been adopted by FASB, but it looks like it will be in the near future. If leases with a term of more than twelve months are recorded as lease liabilities (as presently proposed), then the debt to equity ratio of some companies will, in some cases, be non-compliant with existing covenants. This change in lease accounting will be an impetus to changing debt agreements.

The second cause of changing debt covenants is the AICPA’s issuance of FRF for SME, a new other comprehensive basis of accounting that can be used by small- to medium-sized private companies. If debt covenants presently require GAAP, then debt agreements will need to be amended in order for companies to use FRF for SME.

What do you think? Will these factors result in changes to debt covenants?

Lease Accounting – A Seismic Shift

Given that the comment deadline for FASB’s proposed lease standard is September 13, 2013, I’m thinking that approval will soon be forthcoming.

This standard, if passed, will be a seismic shift in accounting.

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Here are a few general observations:

  • Companies making leasing decisions today need to understand the proposed standard – now; operating leases signed today will likely become lease liabilities in the near future.
  • This standard has the potential to change the way companies do business. Less leasing and more purchasing. If the company is going to record a liability anyway, why not just borrow and buy.
  • Debt covenants may need to be revised once the standard is effective (or before then). Companies with operating leases will probably see their debt to equity ratios adversely impacted as present operating leases become liabilities.
  • Creditors need to consider how the new lease accounting will impact their lending decisions.
  • EBITDA will increase for type A (e.g., equipment) leases since you will add back interest and amortization to earnings; not so for type B (e.g., building) leases (which will be recognized as lease expenses).

Now let’s take a look at the proposed lease standard itself.

The Two Ts: Term and Type

The first important T: Term.

The proposed standard has two important Ts – term and type, with term being the more important of the two (at least in my opinion). A lease with a term of more than twelve months will be booked as lease liability while a lease with a term of twelve months or less will be expensed in the year paid.

So the term of the lease will drive whether a lease is recorded as a liability.

Under the proposed standard, you will simply ask, “is the lease term more than twelve months?” If yes, then book the lease liability (using the present value of the lease payments). In addition, you will book a right-to-use asset (again using the present value of the lease payments).

The second important T: Type.

The standard spells out two types of leases:

  • Type A (Other than Property Leases)
  • Type B (Property Leases)

Think of type A as equipment and type B as buildings or land; the critical determinant of classification, however, is whether the lessee will consume a significant portion of the asset (regardless of whether the underlying asset is equipment or a building). If the lessee will consume a substantial portion of the asset, then the arrangement will be a Type A lease.

Balance Sheet

The lessee will record:

  • A right-to-use asset
  • A lease liability

The initial recording of the right-to-use asset and the lease liability will be the same for Type A and Type B leases, and the computation of both the asset and liability will largely be the present value of future lease payments.

The right-to-use asset will be amortized over the life of the lease; this asset will be presented separately on the balance sheet.

The lease liability will:

* grow (through the unwinding of the discount) and
* decrease as payments are made

The liability will be presented separately on the balance sheet.

Income Statement

In the income statement, type A leases will have:

  • Interest expense
  • Amortization expense
  • Higher expense recognition in the early stages of the lease

In the income statement, type B leases will have:

  • Lease expense (equal to the interest and amortization expenses added together)
  • Straight-line lease expense (similar to operating leases today)

Closing Remarks

Again, this is a simplified overview of the lease standard, but hopefully you’ve found it helpful (even if you felt a few tremors).

At this time, there is no effective date for the standard though I expect FASB to provide one soon.

How About You?

Are you and your clients ready for the change in lease accounting?

FRF for SME – The Lowdown

Well the public brouhaha between NASBA and the AICPA seems to have settled down since the AICPA issued the Financial Reporting Framework for Small- to Medium-Sized Entities (FRF for SME). I won’t say they’re holding hands now, but at least the discussion has simmered.

Here’s a Q&A to help you digest some of the salient points of FRF for SME.

What is FRF for SMEs?

It’s an other comprehensive basis of accounting (OCBOA) that can be used as an alternative to generally accepted accounting principles (GAAP) as issued by the Financial Accounting Standards Board.

When can FRF for SME be used?

Immediately.

Who created FRF for SME?

The AICPA.

What is the size of FRF for SME?

A little over 200 pages.

What is the size of GAAP?

Thousands of pages. (I have heard more than 20,000 pages. Correct me if I’m wrong.)

How often will FRF for SME change?

About once every three to four years. (That’s one of the beauties of it.) Stability? Yes.

Why was FRF for SME created?

GAAP had become too complex for small- to medium-sized private businesses, driving up the costs of creating GAAP-compliant financial statements. Existing OCBOA (e.g., modified-cash basis) lacked standardization.

Does FRF for SME define a small- to medium-sized entity? Is there a dollar threshold?

No. It’s subjective. There is no dollar threshold.

Is “FRF for SME” GAAP?

No. (It is not little GAAP. It is not GAAP at all – not intended to be.)

Can entities with debt covenants requiring GAAP use FRF for SMEs?

No. But they can see if the lender will amend the agreement.

Can financial statements created using FRF for SME be audited, reviewed or compiled?

Yes. Yes. Yes.

What are some of the characteristics of companies that might use FRF for SME?

  • For-profit
  • Closely-held
  • Not a public company
  • No regulatory requirements for GAAP
  • Individuals with controlling ownership also manage the company

What entities should not use FRF for SME?

  • Nonprofits
  • Those with complex transactions
  • Governments

Is FRF for SME principles-based?

Yes. Use the flexibility and disclose the policies used.

Do the FRF for SME financial statements look like GAAP statements?

Yes. This is a downside (at least to me). I do think a user might mistakenly believe the financial statements are GAAP. You will need to clearly disclose that FRF for SME is being used. Also your opinion or SSARS report will refer to FRF for SME (rather than GAAP).

What are some key points of FRF for SME?

  • No comprehensive income
  • Investments will be at historical cost (market value used when held-for-sale)
  • Derivatives (think swaps) are not recognized on the balance sheet (only disclosed); no hedge accounting
  • Goodwill amortized over the same period as that used for tax purposes or 15 years
  • Intangibles (all) will be amortized over their economic life
  • Income taxes recognized using taxes payable method (what you owe at period-end) or the deferred income tax method (as GAAP requires)
  • No requirement to accrue uncertain tax positions (no FIN 46)
  • Leases will be recognized as operating or capital leases (FASB’s presently proposed lease standard will require all leases of more than 12 months to be recognized as a liability; expect to see the FASB lease standard approved in early 2014)
  • Policy choice to consolidate subsidiaries or account for them using the equity method (parent-only presentation allowed; use equity method accounting for subsidiaries)
  • Variable interest entities will not be consolidated (disclosure of the relationship); can I get an Amen?
  • No assessment of long-lived assets for impairment
  • Going concern assessment required by management (this assessment is not required by GAAP – yet)
  • Revenue recognition is principles-based (disclose how you recognize revenue); percentage-of-completion is allowable for contractors
  • Stock-based compensation not booked as a liability (disclosure only)
  • Defined benefit plan liabilities can be recognized using contribution payable method (record current pension plan payments not made; no projected benefit obligation liability required)
  • Disclosure requirements are greatly simplified

Can’t I just continue issuing tax-basis financial statements?

Yes. But tax-basis statements do not incorporate some of the more traditional accounting concepts that FRF for SME does.

How will the use of FRF for SME change the peer review process?

No change; FRF for SME is just another OCBOA – like tax-basis or modified-cash basis.

Does the AICPA offer any implementation tools?

Yes. Click here for toolkits.

How About You? 

Will you and your firm use FRF for SME? Do you like it (or dislike it)?