Maintain Awareness of Potential Debt Covenant Violations

Sept. 2, 2010
To meet the terms of a loan received from its bank, a manufacturer engages a CPA firm to conduct an annual financial statement audit.
Upon examination, the auditor discovers that the company’s working capital/short term liquidity ratio violates one of the debt covenant provisions in the loan agreement.Based on generally accepted accounting principles (GAAP), the auditor informs managers that the company is in technical default on that loan: Because the debt covenant’s terms were breached, the loan is legally regarded as due immediately, with the remaining balance considered a massive current liability.Bankers do not like surprises, but company managers have no choice but to bring the technical default issue to the bank’s attention. The loan’s debt covenant must be renegotiated. Without the banker’s help, the company cannot get out of technical default, which could result in classification of the debt as current or even a going concern issue on its financial statements.Perhaps the banker agrees to a one-year waiver for the debt covenant provision that was breached. The banker may add an addendum to the covenant to address that issue. On a larger scale, the entire loan may be restructured.Renegotiating loan terms incurs fees. The company’s long-term credibility and trustworthiness with the bank suffers, as does the company’s ability to secure favorable future loan terms. Due to delays caused by the need to renegotiate the debt covenant, the financial audit’s completion gets pushed back, causing auditor fees to rise too.Broad economic downturns and acute company difficulties increase chances of a debt services default—the failure to make a scheduled payment on a loan’s interest or principal. A manufacturer does not have to be in financial distress, though, to violate a debt covenant provision and place itself in technical default.A debt covenant violation often is an unintended consequence resulting from an acquisition, disposition, fixed asset addition, implementation of a new accounting standard or some other event. A large bulk purchase of raw material right before a financial reporting period closing, for example, may skew crucial ratios used to determine whether or not the manufacturer is meeting debt covenant terms.Company leaders need to be aware of debt covenant provisions, and consider whether various activities or events may place the manufacturer in technical default. In some instances, a violation may be deemed unavoidable. Identifying such possibilities enables a manufacturer to determine whether or not a waiver, addendum or restructuring of the note would be the most appropriate course to pursue.Contact lenders quicklyWhenever a debt covenant violation seems likely or inevitable, managers should contact the lending institution as soon as possible. Providing early notification of a possible debt covenant breach helps maintain an amicable banking relationship. Note terms can then be renegotiated in a more conducive atmosphere.Promptly addressing such concerns also means that debt covenant issues get resolved before an annual financial audit is scheduled to begin, thereby avoiding costly audit delays. The auditor is in a much better position to issue an unqualified opinion regarding the accuracy and completeness of the company’s financial statements. The annual financial statement subsequently gets released on schedule, thereby promoting confidence among all stakeholders.Marketplace shifts occur throughout the year. General economic conditions fluctuate. Regulatory entities introduce new accounting and compliance standards. Internal needs emerge. Companies face numerous events that influence the ability to meet debt covenant terms. Being aware of the impact that such events may have on meeting debt covenant terms enables manufacturers to address potential note violations and renegotiation needs as soon as they emerge. That attentiveness preserves existing banking relationships, credibility and creditworthiness.Carter Rouse, CPA, [email protected], is a partner in Assurance Services at independent certified public accounting firm Weaver, with offices in Austin, Dallas, Fort Worth, Houston, Midland, Odessa and San Antonio.

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