Recent changes in Generally Accepted Accounting Principles (“GAAP”) have impacted the timing of when certain borrowers recognize revenue for financial statement purposes and how borrowers account for leases on the balance sheet. Lenders and borrowers should evaluate how the new standards impact EBITDA, financial covenants and ratios, available amounts, builder baskets, excess cash flow (“ECF”) sweeps, and a number of other credit agreement provisions.
Defining GAAP in Credit Agreements
Before turning to the new standards, one threshold question is how GAAP is defined in a credit agreement. We typically see two versions. GAAP “as in effect from time to time” would incorporate new accounting standards automatically, while GAAP “as in effect on the Closing Date” freezes GAAP for all purposes in the credit agreement. Thus, though for credit agreement purposes, GAAP may be “frozen in time” as of the closing date, the following analysis assumes GAAP changes are incorporated into EBITDA calculations and other financial covenants and ratios in the credit agreement (i.e., the “as in effect from time to time” standard).
Revenue Recognition (ASC 606)
Accounting Standards Codification 606 (“ASC 606”)—Revenue from Contracts with Customers—will affect the timing of when certain borrowers recognize revenue for financial statement purposes.1 ASC 606’s goal is to have one principles-based standard for revenue recognition across all companies and all industries. The new general rule is that revenue is recognized once each performance obligation is satisfied by transferring control of the promised goods or services to the customer. There are two ways to adopt the new standard – (1) restate historical financial statements (probably costlier), or (2) adopt the new standard prospectively only (attractive but potentially costly—as prior deferred revenue may never be captured). Lenders should be aware of the options selected by the borrower.
The impact of ASC 606 on credit agreements will be primarily derived from (1) timing of revenue recognition—i.e., less deferred revenue, and (2) more cost capitalization. These issues are discussed below.
Timing of Revenue Recognition. Generally, revenue recognition for service businesses may become more “lumpy” as the new standard will diminish the ability to smooth out revenue over time, with much less, or no, deferred revenue in many cases. Where a company previously might complete a performance obligation and recognize revenue over time, now all of that revenue must be recognized up front.
ASC 606 will cause volatility in quarter-to-quarter EBITDA that should be considered in respect of trailing-12-month (“TTM”) measurements in annual, quarterly and incurrence tests, but following the first year of adoption, on a TTM basis, volatility in and of itself should have minimal impact on EBITDA.
Volatility aside, on adoption the change may have a substantive effect on net income and EBITDA calculations because (i) if historical financials are not recast, the first few quarterly periods may result in a blended TTM test period with different pre- and post-adoption recognition numbers, distorting TTM calculations and (ii) the new standard may lead to lost revenue.
Financial covenants and builder baskets that utilize net income or EBITDA will also be impacted, though for purposes of ECF sweeps and available amounts,2 many credit agreements may already include a mitigating mechanism—because the ECF calculation begins with net income and includes changes to deferred revenue as an adjustment to arrive at ECF, any change to net income will be offset by an opposite change to deferred revenue, and therefore will have no impact on ECF. Available amounts and builder baskets that utilize net income or EBITDA (rather than ECF) may not include this mitigating mechanism.
More Cost Capitalization. Certain costs that are currently expensed may instead hit the balance sheet under the new ASC 606 standard. For example, costs incurred to obtain or execute a sales contract—e.g., sales commissions—may be capitalized and amortized over the life of the contract. Again, over time, this should be a change in timing only and not the bottom line, but more capitalized costs in the first few quarterly periods following adoption may increase TTM EBITDA.
Lease Accounting (ASC 842)
Accounting Standards Codification 842 (“ASC 842”)—Leases—will affect how borrowers account for leases on the balance sheet.3 ASC 842’s core principle is to require most lease assets and liabilities to be recorded on the balance sheet (other than those less than 12 months in duration), bringing substantially more lease assets and liabilities onto the balance sheet. The liability is calculated as the present value of lease payments due over the lease term, and the corresponding asset is characterized as a “right-to-use” asset. Importantly, however, for income statement purposes, the new standard preserves the operating / capital lease distinction. A lease is a capital lease if it meets any of five different criteria, and those rules remain essentially unchanged. As a result, net income and EBITDA should remain unaffected for U.S. GAAP.
Conversely, the new standard may have a significant impact in enlarging existing balance sheets. Lenders and borrowers should focus on the defined terms “Capitalized Lease Obligations,” “Indebtedness,” “Consolidated Total Assets,” and “Consolidated Tangible Assets” and any related provision—e.g., financial ratios, grower baskets, and the “Immaterial Subsidiary” concept—to evaluate the effect of an enlarged balance sheet, such as an unintended increase in baskets measured by assets or the loosening of the immaterial subsidiary threshold. Interestingly, it is not entirely clear whether the “right-to-use” asset is a tangible or intangible asset—although there is probably more support for it to be considered an intangible asset.
“Indebtedness” is typically defined to include “Capitalized Lease Obligations,” but the specific language used to define Capitalized Lease Obligations is important. Because the new standard preserves the operating / capital lease distinction for income statement purposes, the drafting formulation “… any lease required to be accounted for as a capital lease for GAAP purposes” may not capture leases brought onto the balance sheet under the new standard, as opposed to any standard using the formulation “required to be recognized as a liability on the balance sheet for GAAP purposes.”