A loan agreement binds the borrower to financial tests, and the borrower's accountant is usually the one who runs them. When a test fails, the bank can raise the rate, demand cure, charge a fee or call the loan, and the balance sheet classification of the debt can change. A firm that handles a client's financial reporting needs to understand the covenants well enough to run them every period, flag trouble early and avoid giving assurance it was not engaged to give. For the accounting rules, see ASC 470 debt classification, covenants and modifications.
What a covenant is
A covenant is a promise in the loan agreement. Affirmative covenants require the borrower to do things: deliver financial statements by a date, maintain insurance, pay taxes. Negative covenants limit actions: additional debt, distributions, asset sales, change of control. Financial covenants require the borrower to meet numerical tests at set dates.
Common financial tests include:
- Debt service coverage. Cash flow available for debt service divided by scheduled principal and interest.
- Debt to earnings. Debt relative to earnings before interest, taxes, depreciation and amortization, or relative to equity. The glossary entry on debt to equity ratio covers the balance sheet version.
- Liquidity. A minimum current ratio, minimum cash or minimum working capital. See current ratio and quick ratio.
- Interest coverage. Earnings relative to interest expense. See interest coverage ratio.
- Minimum net worth or tangible net worth.
Each agreement defines its own terms. "EBITDA" in a loan agreement is whatever the agreement says, with its own add-backs and caps, and it can differ from the client's management definition. Read the definitions page before building any calculation.
SBA-guaranteed loans
The SBA describes its 7(a) program as its primary business loan program, in which the SBA guarantees loans made by lenders. The maximum 7(a) loan amount is $5 million, and the borrower works directly with the lender and not with the SBA. The lender decides what documents it requires based on loan size and processing method. The accountant should therefore get the lender's loan agreement and reporting schedule and not assume the program sets the covenants.
The compliance certificate
A compliance certificate is a signed statement by the borrower, usually by an officer, that it complies with the covenants for a period, with the calculations attached. The firm's role is normally to prepare the schedule from the books at the officer's request, and the officer signs.
Preparing it
- Get the agreement and amendments. Use the definitions and the test dates in the current version.
- Map accounts. Map general ledger accounts to each defined term, and keep the mapping in the file.
- Pull the period figures. Use the same financial statements delivered to the bank, tied to the trial balance. See trial balance.
- Compute each test. Show the formula, inputs and result, and the required level.
- Review headroom. Show the cushion for each test and how a change in earnings or debt would move it.
- Have the officer review and sign. The firm does not sign as an officer.
The firm's role and its limits
The firm can prepare calculations, review the definitions, forecast headroom and suggest actions. It should not tell the bank the borrower is in compliance as though the firm had audited the numbers. If the lender requires an accountant's report on covenant compliance, that is a separate attest engagement with its own standards. See agreed-upon procedures for one form such a request can take and AUP vs review vs audit for how lenders' requests map to engagement types.
Forecasting the tests
The most valuable service is looking forward. A budget model built under budgeting and forecasting for small business clients should include each covenant test by test date. If a downside case breaches, the owner has time to talk to the lender, reduce distributions or change the plan before the date.
When a covenant is breached
- Quantify. Confirm the breach, the amount and the date.
- Check the cure and grace provisions. The agreement may allow a cure or an equity cure.
- Approach the lender early. A waiver requested before delivery of the certificate is better received than one requested after.
- Assess the accounting. A breach that allows the lender to call the loan can require the debt to be classified as current unless a waiver is obtained under the rules. See the glossary entry on debt covenant classification and going concern assessment.
- Document the waiver or amendment. Keep the signed document and update the covenant mapping.
- Modification analysis. An amendment may be a modification or extinguishment. See the 10 percent test.
Common errors
- Using the management definition of EBITDA instead of the agreement's definition.
- Testing at the wrong date or on the wrong period length.
- Missing delivery deadlines for financial statements, which are themselves covenants.
- Treating an anticipated waiver as received.
- Giving comfort to the bank beyond the engagement.
FAQ
Who signs the compliance certificate?
The borrower's officer. The firm prepares the schedule at the client's request.
Can the firm certify compliance?
Only through an attest engagement the lender and the firm agree on. A prepared schedule is not an attestation.
What happens to the debt classification after a breach?
It depends on whether the lender can call the loan and on whether a waiver is obtained, as covered in ASC 470.
CORAA prepares ready-to-review audit files for US CPA firms; see /us.
Sources
- SBA, 7(a) loans: https://www.sba.gov/funding-programs/loans/7a-loans
- SBA, Manage your finances: https://www.sba.gov/business-guide/manage-your-business/manage-your-finances
Part of CORAA University · Quality management and practice: related guides, calculators and templates.
AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error