Keeping covenants: Getting debt ratios right
Journal of Accountancy, June 01, 2018
For some corporate borrowers, a change made by the Financial Accounting Standards Board (FASB) could mean the difference between compliance with a debt covenant ratio and an apparent breach. Analysis Group Vice President John Drum, Managing Principal Richard Starfield, and Co-founder Bruce Stangle explore this concern in “Keeping covenants: Getting debt ratios right,” published in the June 2018 issue of Journal of Accountancy.
The authors show how FASB's Accounting Standards Update (ASU) No. 2015-03 may put some companies at risk of exceeding indebtedness thresholds. They examined the financial statements and terms of indentures for a sample of 89 S&P 500 companies, and found that about 85% of these companies disclosed that ASU No. 2015-03 caused them to switch their accounting treatment for debt issuance costs. Companies close to indebtedness thresholds are most likely to be affected, as the switch could potentially change the amount of debt shown on a company's balance sheet.
The authors also found that a large majority of the terms of indenture lacked any language providing guidance on how to address changes in accounting rules that might affect the calculation of covenant ratios. Absent such language, borrowers and lenders may not have a clearly defined course of action for handling the changes.