What is the status for your loan agreement?

The first quarter of 2019 is coming to an end, and this means not only turning the clock to summertime and waiting for spring to arrive, but also Q1 reporting season approaching fast.

For many IFRS reporting entities the Q1 reporting will be the first financial reporting based on IFRS 16 since its effective date of 1 January 2019.

For lessees, this implies that the financial statements will have to reflect almost all leases, including leases previously treated as operational leases and kept off-balance. IFRS 16 includes certain exceptions, inter alia in respect of the term and value of the lease, but as a main rule most leases will have to be recognised.

In general, the recognition of leases in accordance with IFRS 16 could have the following impact on the lessee’s key figures:

  • Debt will increase with the value of the lease liability whereas the value of assets will increase with the value of the right of use the asset
  • EBITDA will increase as lease payments will be booked as interest expenses (rather than operating expenses as before IFRS 16)
  • Leverage could increase as debt is expected to increase more than EBITDA for most companies
  • Net profit could for certain companies be temporarily reduced as a consequence of a front loading of costs (interest expenses and depreciations) in the beginning of the lease period
  • Equity could also be temporarily reduced due to the reduced net profit.

Most loan agreements includes several references to some or all of these key figures. To neutralise the effect of IFRS 16, many loan agreements entered into over the past years includes a “frozen GAAP” concept, which allows the borrower to report to the banks and test covenants based on historic accounting principles.

However, the specific drafting of the frozen GAAP concept in loan agreements deviates largely. For instance, certain loan agreements solely includes frozen GAAP in respect of the covenant calculation whereas other loan agreements include frozen GAAP solely in respect of the definition of debt and not the other key figures which could be affected by IFRS 16.

Depending on the specific drafting of the frozen GAAP, relevant key definitions and terms, IFRS 16 could affect the loan agreement in several aspects, among others:

  • Financial Covenants: Both leverage, cashflow cover, interest cover and equity ratios could be affected
  • General Undertakings: Restrictions on debt incurrence, dividend payments, acquisitions and negative pledge could be affected if such restrictions are linked to leverage ratio, debt amounts or other key figures affected by IFRS 16
  • Guarantor Coverage: The determination of which subsidiaries that are required to provide guarantees and securities under the loan is usually based on EBITDA, revenue or assets – changes to these figures could thus also affect the guarantor coverage calculation.

Accordingly, as part of the implementation of IFRS 16, we highly recommend a detailed review of the loan agreement in order to verify whether and how the loan agreement is affected by IFRS 16 such that any necessary measures can be taken to avoid that IFRS 16 has any effect beyond the accounting.