Art of Accounting: Blown Covenants
IMGCAP(1)]One time, one of my clients had a very large equipment term loan from a bank and was in danger of being put out of business because the company had blown an essential loan covenant.
A covenant is a condition the lender must meet or the bank has the right to call the loan. Most businesses that borrow cannot pay loans back on demand. Instead, they are paid out of future profits that have hopefully been generated from the added business the loan helped to achieve. In this case, the covenants to maintain net worth and working capital were violated. The company had losses because of noncash charges dictated by accounting rules.
The covenants were based on the net worth as appearing on audited financial statements, but the accounting changes caused the losses while the client had a generous cash flow. When a covenant is not met, the loan becomes due in full. This then requires the loan to be moved from the long-term liability section to the current liability section.
Long-term liabilities do not affect working capital and solvency requirements, but current liabilities do. The second covenant that would be blown was the working capital or solvency ratio, which would change from a strong positive amount to a terribly negative amount.
Well, the bank needed full compliance with the terms of the loan. The loan officer’s ass also was on the line if the full consequences of the blown covenant were realized.
Our report on the financial statements would have had a clause stating that there was doubt the company could consider as a going concern, which would further accelerate very disagreeable banking procedures. The bank would have to call the loan demanding payment and there was no way this could have been done. The company’s debt would then be transferred to the workout section, which would start a super-unpleasant process. (For an interesting picture of how loan workouts are handled, I refer you to the beginning of Chapter 2 in A Man in Full by Tom Wolfe).
Discussions with the loan officer showed that he understood the situation and wanted to help us avoid the wrath of the bank. Because of the size of the loan and the importance to the client, our efforts were not constrained by costs. I put someone on this project for a solid week and together we came up with a memo detailing the situation, the history of the accounting rules, what caused it, the restating of the covenants on a modified GAAP basis without the noncash entries, and a dissertation on the accounting treatment (independent of cash flow) causing failure to meet the conditions of a long term loan.
Further, we prepared projections showing full compliance in the second year. We also offered a solution with all the ramifications considered, including a retroactive modification of the covenants or a waiver of the noncompliance.
We met with the bank president, and because of our memorandum containing a thorough treatment of the issues, he agreed to a waiver of the noncompliance, with the warning that a second waiver was not possible because then it would become a permanent waiver. He also said that the modification was not possible because it would involve an entire rewriting of the loan, which would need to go before the loan committee where the explanation might not be understood. This bought time, and we were able to come up with a permanent solution before the end of the current fiscal year.
The takeaway is that the “pencil needs to be pushed” and serious problems need intense concentration and focus. A business issue for me was that clients need to focus less on accounting fees and more on the efforts to help them succeed and the value of the success of those efforts.
In the whole scheme of things, that week’s work was the cheapest accounting fees he ever paid. Some clients might have resisted giving us a “blank check” to work on this project. Also, we succeeded in this instance, but that might not always be the case. Still, the input would have been the same.
Edward Mendlowitz, CPA, is a partner in WithumSmith+Brown, PC, CPAs. He has authored 20 books and has written hundreds of articles for business and professional journals and newsletters plus a Tax Loophole article for every issue of TaxHotline for 27 years. Ed also writes a blog twice a week that addresses issues his clients have at www.partners-network.com. He is the winner of the Lawler Award for the best article published during 2001 in the Journal of Accountancy. He has also taught in the MBA graduate program at Fairleigh Dickinson University, and is admitted to practice before the U.S. Tax Court. Ed welcomes practice management questions and he can be reached at WithumSmith+Brown, One Spring Street, New Brunswick, NJ 08901, (732) 964-9329, firstname.lastname@example.org.