When, what and why is IFRS 16 important?
On 1 January, lease accounting standards changed, effectively removing the distinction between finance and operating leases, requiring most leases to be reported on a lessee company’s balance sheet as assets and liabilities.
So why does this matter? Well, if balance sheet and debt is being calculated differently, this could impact the financial covenants often found in loan agreements as well as related provisions such as indebtedness and guarantor coverage.
Companies which apply IFRS are required to adopt IFRS 16 for annual accounting periods beginning on or after 1 January 2019 (although they were able to adopt it earlier). For companies that apply UK GAAP there is unlikely to be a change for a few years.
There are exceptions to this new accounting standard, which are:
- short term leases (12 months or less) which do not have an option to buy at the end of the term; and
- leases of low value assets (intended to avoid assets such as tablets or PCs).
The impact on covenants
The LMA brought in optional changes to loan documentation back in 2016. Despite this, the changes have not received much attention in loan documentation. The requirement to disclose operating leases on a balance sheet could impact a variety of financial covenants.
For a company with a significant value of operating leases, Net Debt will increase but so will EBITDA. This means that any covenant that uses either of these could be impacted. The consequence is that covenants such as Interest Cover, Leverage and Cashflow could be affected.
In addition, ‘baskets’ for permitted financial indebtedness could be breached more easily, depending on whether or not fixed or floating GAAP is used (see below). And guarantor coverage provisions that require a minimum gross asset test could be satisfied more easily.
A company’s financial statements may no longer be prepared on the same basis as the Base Case Model. However, borrowers and lenders may have agreed that “frozen GAAP” will apply, effectively preserving the position from before IFRS 16. By contrast, where a borrower and lender have agreed to “floating GAAP” will apply (where the accounting principles applied are whatever those in force are from time to time), any changes in accounting treatment during the term of the loan will be taken into account. Agreeing a frozen GAAP position can therefore ensure that a change of accounting principles does not in itself result in a breach of any covenants when providing financial statements and reporting compliance with those covenants.
However, using frozen GAAP will require a company to prepare parallel accounts (one set that are post-IFRS 16 (to comply with its legal obligations) and another that are pre-IFRS 16) for the purposes of the covenant test. This may not be a suitable long term solution, particularly for organisations with large groups of companies for which they are required to prepare accounts.
Another approach is for the borrower’s auditors to provide a reconciliation statement alongside the company’s latest accounts so that the accounts are based on IFRS 16, but the reconciliation statement shows the pre-IFRS 16 position.
For a company with little finance lease debt, IFRS 16 is unlikely to have any significant impact. Furthermore, if accounts are prepared in accordance with UK GAAP then this is also not a concern.
If you are looking at a loan agreement prepared before 1 January 2019 for a company that prepares accounts in accordance with IFRS, take the opportunity to check whether frozen GAAP is used. Look at the provisions outlining the requirements of financial statements and at the definition of “Finance Lease” and other covenant definitions.
If Frozen GAAP is used, consider whether this should be changed going forward. If not, consider whether covenants are likely to require amendment. There are many factors to consider including how long the facility has left and the borrower’s business. You need to be particularly aware of this if the borrower is in a sector that has heavy reliance on finance leases or, in real estate, is a tenant under multiple long term real estate leases (like, many in the retail and hospitality sectors). If you think changes might be needed, this will likely require a conversation between lender and borrower and the borrower’s accountants.
This blog post was written by Patrick McCoy, Solicitor, Banking and Finance.