The changes arising as a result of the adoption of International Financial Reporting Standards (IFRS) are likely to trigger the need to amend covenants in financing documents for corporate loans.

As companies have been moving to IFRS, many have been relying upon "Frozen GAAP" clauses that allow covenant calculations to be performed on the old UK GAAP basis. This is not sustainable in the longer term and people are already testing covenant compliance under IFRS and revising corporate loan documentation to deal with the new regime.

Why is the transition to IFRS relevant to financial covenants?

Common financial covenants include limiting borrowings by reference to net assets and setting a minimum level of interest cover (the number of times that interest could be paid out of profits), usually by reference to a proxy for "normalised" cash earnings such as EBITDA (Earnings Before Interest Tax Depreciation and Amortisation). Historically EBITDA, as well as other terms used in financial covenants such as Net Assets, have been defined by reference to the borrower's financial statements.

Changes in financial statements introduced by IFRS have been sufficient in a few cases to cause debt covenants to be breached. For companies that have moved to IFRS, debt covenants may need to be drafted differently to reflect the changes to figures required under IFRS to which covenant calculations are tied. As a minimum, it is likely to be necessary to consider whether the changes in terminology under IFRS introduce uncertainty in how covenant figures should be calculated because tying covenants to defined accounting measures offers a level of certainty and robustness in the event of disagreement between borrower and lender.

Whilst these are currently issues for listed companies (see below), issues will also arise for unlisted companies that have remained on UK standards, because these are gradually converging with IFRS.

What is changing?

The main points to note are:

• the lack of prescriptiveness in the formats and required sub-totals of the balance sheet and income statement (formerly called the profit and loss account in UK accounting);


• the differences in terminology and the formats of the financial statements;


• the requirements under IFRS to identify and account separately for certain transactions, e.g. derivatives and leases, that are embedded in other forms of contract; and


• the increasing use of fair values in financial statements, for example for financial instruments and investment property, leading to increased volatility in reported figures.

What is the impact on financial covenants?

Terminology and format issues
Since 1 January 2005, EU companies with securities traded on a regulated market have been required to prepare their consolidated annual accounts in accordance with IFRS. The requirements for the presentation of accounts are addressed in IAS 1 Presentation of Financial Statements, which sets out the requirements for the content of the balance sheet, income statement (in UK terminology the profit and loss account) and other statements. Compared to UK GAAP formatting requirements, IAS 1 is far less prescriptive, making it more difficult to define a "starting place" for calculating inputs into covenants. IFRS also uses terminology that in many cases is different to UK GAAP. Some of the more important specific issues are highlighted below.

The income statement; impact on EBITDA and similar measures
As EBITDA or some other proxy for earnings is usually one of the most important elements of covenant calculations, the presentational requirements for the income statement are particularly relevant. The following items are the only ones that must be disclosed on the face of the income statement:

• Revenue


• Finance costs


• Share of the profit or loss of associates and joint ventures accounted for using the equity method


• Tax expense


• A single amount comprising the total of (i) the post-tax profit or loss of discontinued operations and (ii) the post tax gain or loss recognised on the measurement to fair value costs to sell or on the disposal of the assets or disposal group(s) constituting the discontinued operation


• Profit or loss

IAS 1 also requires the income statement to disclose separately the profit or loss attributable to minority interests and that attributable to equity holders of the parent.

There is thus no requirement for any particular defined sub-totals or totals to be given, except the line item relating to discontinued operations and the total profit or loss for the period at the bottom of the income statement. The UK GAAP terms "Operating profit" and "Profit on ordinary activities" are not defined or used in IFRS. As IAS 1 defines only "Profit or loss for the period", this should perhaps be used as the starting point for the definition of EBITDA; however, it will require a greater number of adjustments to get to EBITDA, which will therefore require more extensive drafting.

There are several other changes under IFRS that will affect the income statement.

Firstly, gains and losses arising from items held at fair value will, to some extent, hit the income statement. Investment property companies have seen very significant movements in their reported profits due to the requirement to hold investment properties at fair value, with revaluation gains and losses recognised in the income statement (with related tax effects). They have often excluded these movements from alternative reporting measures in their financial statements.

Secondly, share options granted to employees and directors now have to be measured at fair value at the date they are granted, and are recorded as an expense over the vesting period. Companies may wish to exclude such charges from the calculation of EBITDA.

Thirdly, an important terminology point relates to extraordinary and exceptional items. Under IFRS, if there are any items that are considered material, then their nature and amount should be disclosed separately. Such items are similar to those that would have been classified as "exceptional items" under UK GAAP, which have often been excluded from EBITDA for the purpose of covenant calculations. Importantly, however, the term "exceptional item" is not defined or used in IFRS, nor is an alternative term offered, although IAS 1 gives examples of such material items including: restructuring costs; write-down costs; litigation settlements; as well as any provision reversals. The presentation of extraordinary items (i.e. after tax unusual items) is specifically banned by IAS 1 and so the term will probably become obsolete over time.

Fourthly, lenders and borrowers will need to consider how to treat gains and losses that are reported directly in equity, i.e. that initially bypass the income statement. Some of these will be reported in the income statement in future periods, for example when the related asset is sold; others, however, will not. Again, this introduces some randomness into the figures used for covenant calculation purposes, depending on the type of company involved.

The balance sheet: net assets and indebtedness measures

In relation to the balance sheet, there are several key changes that a company should evaluate in the context of its financial covenants.

Firstly, preference shares are generally classified as financial liabilities under IAS 32, causing the level of net assets to decrease.

Secondly, the requirement to place pension liabilities (for defined benefit schemes) on balance sheet will impact on the level of financial liabilities on the company’s balance sheet, although the UK standard FRS 17 means that the company may have already been showing pension liabilities in full. The international accounting standard, IAS 19, is similar but not identical to FRS 17.

Thirdly, IFRS requires identification of certain types of contract that may be sitting in other host contracts. Some of these are called "embedded derivatives" and will in many cases have to be measured at fair value, but companies will also have to identify leases sitting in other contracts which, if they are classed as finance leases, may increase borrowings.

Fourthly, the widespread use of fair value may increase the value of net assets, especially in relation to investment property. However, the requirement of IFRS to hold derivatives (which can be assets or liabilities) on the face of the balance sheet at fair value under IAS 39 will lead to greater volatility, both in net assets and in reported earnings.

What should you do?

Bankers and lawyers drafting debt covenants should always be mindful of the changing landscape of accounting. Further changes are already under consideration that would alter the structure and content of the income statement and other changes are likely over the next few years. It therefore pays to ensure that some acknowledgement of this is included in debt agreements, either taking a "frozen GAAP" approach and/or by providing for a process for agreeing any changes in financial covenants to deal with major accounting changes and restore the original position of the parties.
As accounting grows more complex, it may be tempting for both borrowers and lenders to exclude the impact of some of the standards from covenant calculations, for example those requiring measurement at fair value. Although this may simplify things, it has inherent dangers as part of the borrower's performance and risk exposure may bypass the covenants altogether. For example, by removing entirely the impact of IAS 39 fair value changes, all derivative positions will be left out of the calculation, even when the derivative position closes out. Lenders to companies with sophisticated treasury functions that make extensive use of derivatives may find that covenants that exclude the impact of such derivatives are effectively ignoring a large part of the company's financial performance.

Kathryn Cearns is the Consultant Accountant at City law firm Herbert Smith. The views expressed here are her own.