By Mike Westervelt Principal CliftonLarsonAllen Email T. 704.998.5288
- Read debt agreements fully and consider restrictions as you address debt covenant compliance.
- Review PPP loan forgiveness considerations and the potential impact on your financial reporting and tax strategy.
- In response to interest rate manipulation, LIBOR will be discontinued on December 31, 2021.
2020 will be a year to remember. With the economic landscape in flux, many businesses were forced to reposition, respond, and even restructure financing needs. Some organizations obtained additional financing through the Paycheck Protection Program (PPP) or Economic Injury Disaster Loans (EIDL). Review areas related to debt compliance, financing needs and reporting considerations to potentially turn these challenges into opportunities.
Debt covenant compliance
COVID-19 likely has resulted in many entities experiencing economic and operational uncertainties. Changes in operations during 2020 in response to these challenges may have unintentionally resulted in noncompliance with debt covenants.
Types of covenants
- Require achieving a threshold in certain financial ratios
- Include limitations on dividends over a certain amount or type
- Disallow the sale of certain assets
- Include limitations not allowing additional debt
- Provide yearly audited financial statements
- Include accounting practices in accordance with generally accepted accounting principles (GAAP)
Possible penalties for violation
If an organization violates their covenant, the lender could:
- Demand penalty payment
- Increase the predetermined interest rate
- Increase the amount of collateral
- Demand full immediate repayment of the loan
- Terminate the debt agreement
What should you do now?
- Read debt agreements to understand requirements
- Consider restrictions of additional debt in existing debt agreements
- Consider other restrictions
- Understand financial covenants and ratios
- Consider interim covenants
- Keep in mind, your entity may meet its year-end covenants, but failed to meet covenants in earlier measurement periods. If you did not receive a waiver for these violations, the debt is technically in default.
- Understand the bank’s intentions
- Obtain waivers for noncompliance when needed
Debt covenant violations and related waivers may take longer than normal to resolve. Banks are experiencing a significant backlog in requests and may need more time to evaluate your organization’s financial condition.
If you are not able to address such violations in a timely manner, you may experience delays in the issuance of your financial statements, reclassification of the debt for financial reporting, and possible going concern issues.
PPP loan forgiveness
Most entities have likely expended funds received from their PPP loans to pay for approved expenses, such as payroll. As you look toward other financing options, remember that your balance sheet may be encumbered by outstanding PPP debt.
That means that you will have a number of decisions to make concerning your PPP loan. In the coming months, address topics related to GAAP financial reporting, the timing to file for PPP loan forgiveness, and the treatment of costs paid with PPP funds for tax purposes. Your need for additional working capital could greatly influence the answer on many of these matters.
Our COVID-19 Response Page has the resources to help plan your response to the pandemic and your strategy moving forward. Review topics, including:
- Operational support
- Regulatory and tax updates
- Inspirational and leadership tips
- Financial management and disaster relief
- Accounting and financial statement guidance
- Workforce, human resource, and benefits guidance
Discontinuation of LIBOR
In response to interest rate manipulation, the London Interbank Offering Rate (LIBOR) will be discontinued on December 31, 2021. LIBOR is widely used by financial institutions and entities alike. The U.S. Federal Reserve Bank’s Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financing Rate (SOFR) as the preferred alternative rate to LIBOR; however, other alternative rates are available.
This change may have accounting implications. The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, in March 2020. The amendments in the update provide optional expedients and exceptions for applying GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform, if certain criteria are met.
The objective of ASU 2020-04 is to provide guidance for accounting and reporting implications when replacing benchmark interest rates, such as LIBOR, by permitting optional expedients for contracts that are modified because of reference rate reform and that meet certain criteria.
Consideration: Financial institutions are beginning the process of selecting and implementing an alternative rate and should be coordinating with their borrowers to update loan documentation. As your business enters into modified debt agreements with your financial institutions, you should consider the reference rate used and the election of practical expedients available to you under ASU 2020-04.
These amendments are effective for all entities as of March 12, 2020, through December 31, 2022. Note the amendments do not apply to contract modifications made after December 31, 2022, and other hedging relationships. If an entity has not adopted ASU No. 2017-12, Derivatives and Hedging (Topic 815), not all optional expedients may be elected.