Insight - The fine print

Assessing the impact of international financial reporting standards on financial covenants has not been top of the ‘to do’ list for most finance directors in the countdown to the switchover. But now, with the transition process in full swing, it is becoming a critical issue.

“The focus within many organisations has been on resolving pure accounting and systems issues. Less attention has been devoted to some of the more commercial aspects associated with IFRS, yet these could have a material impact,” according to Brian Lochead, a business recovery partner at PricewaterhouseCoopers.

Key performance indicators historically used as the basis of financial covenants could be affected adversely by IFRS. Some companies could find themselves inadvertently breaching financial covenants, even though their underlying trading position remains the same.

“Companies could fall into technical default if they do not conduct a thorough borrowing review. This default situation might not become apparent until the next due date for checking. By then it could have triggered cross-covenant defaults, which is potentially very serious,” says Kathryn Cearns, a consultant accountant at Herbert Smith.

The companies most at risk are likely to be those that are already facing difficulties associated with some element of underperformance or a deteriorating relationship with lenders. At-risk borrowers might also have covenant packages that allow limited flexibility because, for example, they involve multiple agents.

Existing loan documentation may allow covenants to be calculated on the basis of frozen GAAP provisions. However, says Lochead: “Frozen GAAP can only be a temporary solution; it is unlikely that corporates can continue to report in both local GAAP and IFRS indefinitely.”

However, Edward Evans, banking partner at Freshfields, believes that until companies are certain of their post-IFRS position, most are likely to rely on frozen GAAP. “Borrowers will not want to agree new covenants and then have to go through the process all over again because their situation has changed under IFRS,” he says.

“Frozen GAAP is the best way forward if a company knows that IFRS is not going to alter its figures radically, or if it has debt instruments due to expire or be renegotiated. But, in essence, it is a short-term measure. Bankers will ultimately want covenants tested against published and audited numbers,” says Cearns. “This is also an area that auditors – with their specific liquidity and going concern requirements – will look at quite carefully,” she says.

For long-term debt instruments, renegotiation is necessary, even if a breach is not likely. “The terminology may be too specific to UK GAAP. But if companies renegotiate in good faith, then the quantum of the lending should not change,” says Cearns.

In theory, companies should, by now, have restated their transitional balance sheets, carried out trial runs on their 2004 figures and thus be in a position to analyse how their financial covenants will be impacted by IFRS.

But the reality, suggests Lochead, is that many companies outside the top tier are on the drag with regard to their IFRS preparations. “And, unfortunately, if the issue of covenants is dealt with late, lenders could take a more aggressive stance,” he warns.

“There could be problems if companies are running behind schedule, although as long as their relationships with lenders are good, there should still be time for sensible renegotiations. Companies which are borderline may have more cause for concern,” says Cearns.

Edward Evans points out that the impact of IFRS is generally cushioned by the current benign economic climate. “It would have presented a far greater threat two or three years ago. Relatively few companies are now overstretched, covenants are less tight, so it is less of a drama,” he says.

“The major concerns for finance directors are that this aspect of IFRS presents quite a lot of work, they may not know how best to deal with it, or may not have the right systems in place. It may also be a problem presentationally, although the beauty of covenants is that they are privately documented,” says Evans.

The consensus among advisers seems to be that if corporate borrowers think there is any possibility that they will breach their financial covenants, then the responsibility lies with them to do something about it.

“This means being proactive and communicating effectively – well in advance of reporting dates – with financial stakeholders. And go armed with a well-documented, fully researched business case. This will be critical in gaining a strong position when negotiations commence,” says Lochead.

“Forward-planning is vital if companies want to be in a favourable negotiating position with their lenders – particularly if those lenders want to be difficult,” agrees Cearns. “But ultimately, IFRS is a bit like YK2: if companies prepare, plan and project-manage the process properly, they will be fine,” she concludes.