On 22 July 2015, a public survey was launched to assess the possible impact of new lease accounting standards on financial covenants in loan agreements. Responses to the survey should be submitted by 30 September 2015.
New lease accounting standards
The International Accounting Standards Board (IASB) has proposed certain changes to the existing lease accounting requirements, and intends to announce the effective date for the new International Financial Reporting Standards (IFRS) on leases by the end of 2015.
The main change will be that lessees will be required to recognise assets and liabilities for all identified leases (subject to limited exceptions), including operating leases and finance leases. Currently, lessees only need to recognise finance leases.
Impact on financial covenants
Financial covenants in loan agreements will often use ratios to measure ‘debt’, ‘net financial position’, ‘interest cover’ and/or EBITDA*. The definitions of the relevant covenant terms will be crucial in determining whether the new IFRS on leases could lead to issues for borrowers, particularly those with material leases, in complying with their covenants.
For example, if a borrower’s financial covenants are to be calculated by reference to IFRS, the fact that they will need to start recognising leases that were previously off-balance sheet may impact whether they can continue to meet the covenant ratios at the levels agreed in the loan agreement.
Lenders and borrowers may, however, have already agreed financial covenants that take into account off-balance sheet lease commitments, in which case the impact of the new IFRS on leases will be more limited. They may also have agreed that the covenants will be calculated by reference to accounting standards in place when the loan agreement was entered into, so IFRS changes will not affect the covenant calculations.
In order to assess the impact of the new IFRS on leases on financial covenants across Europe, the survey referred to above has been launched. All entities are encouraged by the Financial Reporting Council, the European Financial Reporting Advisory Group, the IASB and other National Standard Setters to participate in the survey.
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*Earnings before interest, taxes, depreciation and amortisation