Boards should understand impact of IFRS on Debt covenants

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What are Boards, CFOs and CEOs doing about potentially breaching bank covenants for debt and equity with the advent of new accounting standards? Many companies may inadvertently breach debt covenants because they’re not prepared for the changes coming through with new IFRSs. CFOs should be advising their boards to seek amendments to existing bank agreements to address implications of issues arising from the adoption of IFRSs. 

Boards need to realize that a breach of covenants will require reclassification of long term debts. CFOs who are facing refinancing of loans should be cognizant of the impact of new IFRS changes on covenant calculations when renegotiating covenants. Some of he key ratios affected include; earnings before interest, taxes, depreciation, and amortization (EBITDA), leverage ratios and fixed charge covenants. Some key drivers of change in critical ratios may include the following changes:

Financial instruments’ expected credit loss (ECL) model:

ECL estimates are likely to be material to many bank financial statements, reducing their equity. ECL estimation is complex and inherently judgemental. It is dependent on data about forward-looking estimates of key macro economic factors and other management’s assumptions. Non banking institutions also may see an impact of ECL provisions. These will affect earnings and equity in many industries though the most significantly affected will be the banks/finance industry. 

Revenue recognition:

IFRS 15 necessitates an evaluation of customer contracts to ensure that revenue is recognized when performance obligations are satisfied. Some revenues recognized over a period may become point in time contracts. This change will alter the timing of earnings and EBITDA in particular industries.

Lease accounting: 

The new lease accounting standard will result in some of the following changes:

– Operating lease being recorded on the balance sheet

– Lease rental expense will be replaced with depreciation/amortization and interest expense, impacting EBITDA

– As interest expense under the effective interest method plus depreciation will be higher in early years, compared to the current straight-line recognition of rental expense under an operating lease, profits will reduce in the early years. 

The increase in liability discounted using effective interest method whereas the related asset will be depreciated on straight line along with the impact on EBITDA needs to be considered when determining covenants. 

Insurance contracts:

Though this standard is applicable in 2021, the significant change made to accounting specifically for life insurance contracts will change the outlook of balance sheets and P&L of Insurance companies. Boards still don’t understand how to react to these changes. 

Boards and CFOs should have already considered the impact of the above accounting rules and negotiated amended bank agreements. CFOs may have convinced their lenders to calculate covenants using the GAAP rules in effect when the loan agreement was signed. Otherwise, it’s time to negotiate some flexibility to those loan agreements to manage the impact of these changes on the company’s compliance with its debt covenants. 

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About surenraj

“Views expressed are my own”
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