How to Prevent Your Shop Bank Loan from Tripping

For the most part, the collapse of Enron and other similar accounting scandals have had minimal direct impact on the day-to-day management and operations of most small and midsize non-public businesses here in the U.S.—until perhaps now. The highly-publicized fraudulent financial reporting by Enron has put pressure on accounting standards setters to reconsider the question of when the financial statements of related entities need to be fully-included in a business’ financial statements. Although Enron initially focused attention on a technique in which a company designs a separate entity so that consolidation is not required, and then transfers unprofitable activities or debt to it, the breadth of the new standard has now snared many smaller businesses, too.

Over the years, many entrepreneurial business enterprises have looked at a variety of ways to structure certain financing activities so as to not impact the company’s financial results. While that may initially conjure up images of exotic financial transactions and sinister “off balance sheet” dealings, common, less-complex, plain vanilla instruments are often used—such as equipment leases, real estate leases and guarantees. Although a number of valid business reasons exist for a privately-owned business to house operating assets in a separate entity (for example, to protect real estate from lawsuits against the operating entity, to avoid unfavorable tax consequences and for family estate planning), many of these innocent and well-intentioned techniques are now within the scope of the new “consolidation” standards.

 

Get to Know the New Accounting Standards

Beginning in 2005 and going forward into 2006 and beyond, these new accounting standards will require many related, formerly “off balance sheet” entity’s assets, debt, liabilities, income and expenses to now be consolidated in the operating business’ financial statements. Unfortunately, in many cases, the impact of reporting these activities in the business’ financial statements will not be evaluated until after year end, and will result in many business’ bank loan covenants (and for some, bonding company requirements) to be tripped, and the company to be in default of its loan agreement. These covenant violations could include bank requirements for the business to maintain or limit certain levels of debt, debt-to-equity, cash flow, interest expense and distributions to owners, and will require adjustments to or waivers of the tripped covenants by the bank to cure.

 

Standard Effects on Your Shop

Let’s look at a practical, everyday example as to how the new consolidation standards could unexpectedly impact a privately-held manufacturing company. First, assume a manufacturing company (“Company A”) has only one shareholder. As is fairly common in privately-held businesses, the shareholder also owns the real estate that is used by Company A, but holds this real estate in a separate entity, which leases the property to Company A. Company A leases the real estate from the entity where the terms of the lease parallel the terms of the loan. The real estate entity was initially capitalized by the owner with a small capital contribution, say 5 percent, with the remainder of the funds for the real estate borrowed from a financial institution. To approve the loan, the financial institution required a personal guarantee from the owner. Under the new consolidation standards, because the real estate entity did not have sufficient equity at risk and the lending institution required a guarantee of the loan by the owner (who also owns Company A) and since Company A is the primary user of the real estate, Company A’s financial statements must now include/consolidate the real estate entity.

Prior to 2005, because Company A did not directly own or control the real estate entity, it would not have been required to include the real estate (including related debt, income and expenses) in its financial statements and would have generally only been required to disclose the transactions in a footnote to its financial statements.

Consolidation of the real estate entity also would be required under similar scenarios whereby Company A directly (instead of the owner) was required to guarantee the loan, or where Company A distributed or loaned money to the shareholder, which was used as the source of the capital contribution to the real estate entity—even if a guarantee of the loan was no longer required. Additionally, different evaluations (and perhaps different conclusions) would result from different ownership structures, lease terms, initial equity contributions and borrowing levels.

 

Understand the Impact

The specific impact of these standards will vary from company to company depending on the specific facts and structure of the relationship with the related entity. The end results also will vary from requiring consolidation of the related entity to just adding some additional disclosures to the financial statements. Generally, loan agreements and bonding companies require company financial statements that fully comply with generally accepted accounting principles (“GAAP”). The ultimate goal of financial statements, however, is to present useful information to a reader for their intended purpose. Consolidating the operations a related entity that is not directly involved in the performance of the business that supports the loan or the bond may actually “muddy the water” in permitting the banker or bonding agent to evaluate the creditworthiness or compliance of the borrower. Alternative approaches to consider would be to prepare the financial statements on other than a GAAP basis, disclosing the departure from GAAP rather than consolidating or presenting additional supplementary information. In any event, the key to a smooth transition is to take the time now to understand and work through the required complex evaluations with your accounting firm and, if necessary, address the impact and the options with your banker and/or bonding company on a proactive basis, well in advance of any year-end surprises.