A covenant breach at the balance sheet date can turn a long-term loan into a current liability, and with it a working capital deficit and a going concern question. Management often tests the covenant on its own unaudited numbers in January and reports compliance. The audit recomputes it on the final numbers. This post walks through the recompute, the waiver, the classification and the consequences. For the accounting rules see ASC 470 debt classification and covenants. This post is the auditor's recompute and classification test. For how covenants work and what the CPA firm can do for a borrower (preparing compliance certificates, forecasting headroom), see bank covenants, compliance certificates and the CPA firm's role.
Step 1: List every covenant
Read each loan agreement and abstract the covenants. Include:
- Financial covenants: debt service coverage, fixed charge coverage, leverage (debt to EBITDA), current ratio, minimum net worth, minimum liquidity.
- Reporting covenants: deliver audited statements within a set number of days, compliance certificates and borrowing base reports.
- Negative covenants: limits on dividends, additional debt, capital expenditures, asset sales and changes in control.
- Testing dates: quarterly, annually, or on a trailing basis.
- Definitions. Covenants rely on defined terms: EBITDA as defined in the agreement, with add-backs, caps and exclusions that differ from GAAP.
The definition section matters as much as the ratio. A ratio recomputed on GAAP numbers when the agreement allows add-backs gives the wrong answer in both directions.
Step 2: Recompute from the audited numbers
Take the final adjusted trial balance, apply the agreement's definitions and compute each ratio at each test date. Compare to the client's compliance certificate.
Illustrative example. The loan requires a debt service coverage ratio (DSCR) of at least 1.25 times, tested annually at year end, defined as EBITDA (as defined) divided by scheduled principal and interest.
| Item | Management certificate | After audit adjustments |
|---|---|---|
| Net income | 1,020,000 | 905,000 |
| Add: interest | 310,000 | 310,000 |
| Add: depreciation and amortization | 640,000 | 640,000 |
| Add: income taxes | 0 (pass-through) | 0 |
| Add: permitted add-back (agreement allows non-cash stock comp) | 60,000 | 60,000 |
| EBITDA (as defined) | 2,030,000 | 1,915,000 |
| Scheduled principal | 900,000 | 900,000 |
| Interest | 310,000 | 310,000 |
| Total debt service | 1,210,000 | 1,210,000 |
| DSCR | 1.68 | 1.58 |
The audit adjustments reduced net income by $115,000 for an unrecorded accrual and an inventory write-down, and the ratio is still above 1.25. Compliance holds. If the audit adjustments had been $700,000, the ratio would be 1.10 and the covenant would be violated.
Run the sensitivity too. If the ratio is close, document the margin and what additional adjustments would breach it, and confirm that no unrecorded or passed adjustments, taken together, would push it over. Test the ratio with and without the passed adjustments on the summary of uncorrected misstatements, because a lender measures compliance on the corrected numbers and a small passed item can still tip a tight ratio.
Step 3: Test the lender's compliance evidence
Request the compliance certificate sent to the lender and any lender correspondence on compliance, notices of default, reservation of rights, waivers or forbearance. Confirm with the lender directly. The bank confirmation should ask about defaults and waivers. See bank confirmations step by step.
Step 4: If there is a violation, test the waiver
A waiver letter should be examined for four features:
- Who signed it, and whether that person has authority.
- The covenant and period covered. A waiver of the year-end test does not cover the next quarter.
- Whether the lender waives its right to demand repayment for more than one year from the balance sheet date, or only "for now."
- Conditions. A waiver that is subject to a fee, a rate increase or a cure by a date has to be read with those conditions.
Under the accounting guidance, debt is classified as current when a covenant violation at the balance sheet date makes it callable, unless the creditor has waived or lost the right to demand repayment for more than one year (or the operating cycle) from the balance sheet date. Even with such a waiver, if it is probable that the entity will violate a covenant at a measurement date within the next twelve months, the debt is classified as current (ASC 470-10-45-1). The waiver must be in hand before the financial statements are issued; one obtained afterward does not change the classification. A waiver that covers only the past violation does not remove that look-ahead.
Step 5: Classify and compute the effects
If the debt is reclassified to current, recompute working capital and the current ratio. Test other agreements for cross-default clauses. A violation under one loan often triggers cross-default under others, which moves them to current as well.
| Scenario | Classification | Effect |
|---|---|---|
| No violation, no probable violation | As scheduled | Current portion only |
| Violation at year end, waiver for more than one year, and no probable violation at later test dates within the year | Noncurrent | Disclose the violation and the waiver |
| Violation at year end, waiver covers only a short period | Current | Working capital falls; assess going concern |
| Violation probable at a future test date within the year, with or without a waiver of the past violation | Current | Reclassify and disclose; assess going concern |
Step 6: Going concern consequences
A callable loan that the client cannot repay is a going concern condition. Management's assessment under ASC 205-40 looks one year after the financial statements are issued, and the auditor evaluates that assessment, including management's plans: refinancing commitments, asset sales, cure by equity. See going concern assessment and management plans evaluation. Representations about the covenant status and plans go in the representation letter.
Step 7: Disclosures
Tie the note to the work: covenants in force, whether the entity is in compliance, any violations and waivers with dates, the reclassification and its basis, and the going concern language when applicable.
Worked example continued
At year end the client breached a minimum current ratio covenant of 1.20 with a computed 1.12 after audit adjustments. Management showed the auditor a waiver dated January 18 signed by the lender's credit officer. It waived the December 31 test only, and stated the lender "reserves all rights" at the next test date. The current ratio at March 31 was forecast at 1.10, so a further violation was probable within the year. The auditor concluded that the waiver did not remove the lender's right to demand repayment within a year, reclassified the $2.1 million term loan to current, evaluated going concern with management's refinancing plan and the lender's draft term sheet, and added a note disclosure. The reclassification and the evaluation are in the file with the partner's sign-off.
Documentation checklist
- Covenant abstract with definitions.
- Recompute by test date with sensitivity.
- Compliance certificate and lender correspondence.
- Waiver analysis if applicable.
- Classification memo and cross-default review.
- Going concern evaluation if triggered.
- Disclosure tie-out.
CORAA prepares ready-to-review audit files for US CPA firms; the firm keeps the client, the review and the signature. See /us.
Sources
- AICPA, AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern; AU-C Section 505, External Confirmations
- FASB, Accounting Standards Codification Topic 470, Debt, and Subtopic 205-40, Going Concern
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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