Avoiding a Revenue “Wreckognition” Nightmare-
How the new Revenue Recognition Standard Could Impact Debt Covenants
The way entities recognize revenue and certain expenses associated with obtaining or fulfilling contracts is changing as a result of the new revenue recognition accounting standard (ASC Topic 606). It is important that entities understand the impact of these changes on financial metrics impacting their debt covenants so that Rev Rec does not become a Rev Wreck!
While the underlying economics and cashflows of transactions remain unchanged, the new accounting standard could dramatically change the way these transactions are accounted for. In particular, adoption of the new revenue recognition standard (mandatory for all non-public entities with reporting periods commencing on/after December 15, 2018) could impact financial metrics including:
- EBITDA (earnings before interest, taxes, depreciation, and amortization), from:
- Revenue recognition that is accelerated or deferred.
- In particular the proposed treatment of “material rights” (e.g. a right to renew ac contract at a discounted price) could significantly defer revenue recognition and negatively impact EBITDA and net worth.
- Costs that are capitalized
- Current / non-current assets, from
- Costs that are capitalized
- Current / non-current liabilities, from
- Deferred revenue.
- Retained earnings / net worth, from
- Changes in timing of recognizing revenue / expenses
- Adjustments to contract balances upon adoption of the new standard
The repercussions of changes in financial metrics could impact all kinds of contractual arrangements including, but not limited to: executive compensation, sales compensation, employee profit share, earnouts and loan agreements.
In regards to loan agreements, changes in financial metrics commonly used to calculate debt covenants could be enormous. Several ratios commonly tied to debt covenants could be impacted including:
- Leverage ratio (total funded debt to EBITDA)
- Debt service coverage
- Total debt to net worth
- Interest coverage
- Tangible net worth
- Current ratio
- A software company sells its software with associated PCS for $200,000 payable at time of signing.
- The salesperson earns a 10% commission on the sale also payable at time of signing.
- The customer is expected to use the software for 3 years.
- Software maintenance is estimated to be 20% of the software license purchase price (per annum).
Download our spreadsheet comparing the impact on reported financial results (income statement, cash flow and balance sheet) and debt ratios under legacy GAAP (ASC 605) and new GAAP (ASC 606) under 4 different scenarios:
- Perpetual software license VSOE available
- Perpetual software license VSOE not available
- 3 year on premises license
- 3 year SaaS subscription
What steps should entities take to proactively mitigate this risk?
- Review your loan documents to ascertain which, if any, metrics used in calculating debt covenants might be impacted by changes in the timing of revenue (and certain associated expense) recognition.
- Undertake an impact assessment to quantify the impact of adoption on your financial metrics and loan covenants?
- Engage legal counsel and/or third-party experts as necessary to assist you in this process.
- Contact your banker as soon as possible If adoption negatively impacts covenants to discuss your findings and ascertain the level of flexibility regarding.
- Request Structured loan modifications which could include some/all of the following:
- Waiver and/or
- Loan modifications to:
- Amend covenant definitions and/or thresholds to offset the estimated impact of the change in accounting policies.
- Permit the entity to continue to use GAAP as it existed at the time the loan closed.
- Thorough preparation and planning can minimize the time (and potentially the fees and costs) associated with getting a waiver / loan modification
- Refinance debt with another lender if current agreements cannot be modified.
It is important that entities understand the impact of the changes in accounting standards on reported financial results and on ratios tied to debt covenants. Don’t let Rev Rec become a Rev Wreck!
If you would like additional information please contact us at email@example.com or request a consultation with us today.