IAS 1 The best and proven breached loan accounting – Loan agreements often include covenants that, if breached by the borrower, permit the lender to demand repayment before the loan’s normal maturity date. In response to a borrower’s request, lenders may decide to voluntarily waive some or all of the rights they acquire as a result of a breach.
IAS 1 Presentation of Financial Statements IAS 1 The best and proven breached loan accounting
IAS 10 Events after the Reporting Period IAS 1 The best and proven breached loan accounting
IFRS 7 Financial Instruments: Disclosures IAS 1 The best and proven breached loan accounting
Condition of the loan
Classification of a long-term loan payable as either a current or non-current liability is based on the existing rights of the borrower and lender (the ‘condition of the loan’) at the reporting date: IAS 1 The best and proven breached loan accounting
- when a borrower has the right to defer settlement for at least 12 months beyond the reporting date, a loan is classified as non-current
- the anticipated outcome of future covenant tests (based on financial conditions existing after the end of the current reporting period) does not influence the classification of a loan at the reporting date IAS 1 The best and proven breached loan accounting
- when assessing the impact of waivers, it is important to consider both the timing of the waiver and how it affects the rights of the parties at the reporting date.
The more detailed comments below assume that a breach of a borrowing covenant entitles the lender to require repayment on demand.
Effect of a covenant breach on classification
Loan covenants can take many forms. A typical example requires a borrower to maintain one or more key financial ratios (such as interest cover or a debt-to-equity ratio) above or below a specified benchmark. When a borrower breaches a covenant on or before the reporting date, the loan should be classified as current if the borrower does not have the right to defer settlement for at least 12 months after the reporting date. IAS 1 The best and proven breached loan accounting
The assessment of whether a long-term loan should be classified as current or non-current is based on the condition of the loan at the reporting date. This means that:
- if a company breaches a covenant before the end of the reporting period and as a result does not have the right to defer payment for a period of at least 12 months following the reporting date, the loan is classified as current (IAS 1 69(d)) IAS 1 The best and proven breached loan accounting
- If an entity breaches a covenant after the end of its reporting period but before the date of approval of its financial statements, this is a non-adjusting event in accordance with IAS 10. This matter should be disclosed in accordance with that Standard (along with the matters referred to IAS 1 76). Information received that provides evidence of the entity’s financial condition at the period end and indicates a breach of a covenant that is assessed based on period end conditions is an adjusting event
- when information comes to light after the end of a reporting period indicating that covenants have, in fact, been breached at period end, this is an example of an adjusting event and the loan is classified as current (IAS 1 74) IAS 1 The best and proven breached loan accounting
- the anticipated outcome of future covenant tests (based on financial conditions existing after the end of the current reporting period) does not influence the classification of a loan at the reporting date. This is true even when the borrower believes it is likely that it will ‘fail’ the future tests
- Classification is based on whether the borrower is in breach of the covenant at the reporting period end, regardless of whether the breach has been reported to the lender at that date. For example, where a breach of a covenant is reported to the lender after the reporting period end but the assessment is based on the financial condition of the borrower at the reporting date, this will result in classification of the loan as current. IAS 1 The best and proven breached loan accounting
Food for thought
A convertible loan may allow the lender to elect to receive shares of the borrower in settlement of the amount owing in advance of the loan’s normal maturity date. Even when exercisable immediately, these rights will not affect the loan’s classification.
A lender may however grant a waiver of its right to demand repayment following a covenant breach in order to allow the borrower time to rectify the breach. The terms and conditions attached to waivers, along with their timing, should be carefully assessed to determine the effect on loan classification. For example, a waiver may:
- defer the lender’s demand rights to a later date at which time the lender can decide whether to require settlement
- be an unconditional ‘forgiveness’ of the past breach such that the lender no longer has a right to demand repayment and will have no automatic right in future
- be conditional on future rectification actions by the lender which are in effect new or additional covenants.
Where the entity obtains a waiver in respect of the breach before the reporting date the loan is classified as non-current if the effect is to defer the lender’s right to demand repayment for a period of at least 12 months from the reporting date (IAS 1 75). IAS 1 The best and proven breached loan accounting
In other cases, a lender may agree to waive a covenant breach before the end of the reporting period, but require another test within 12 months of the reporting date. As a result of this type of waiver, the past covenant breach in effect no longer exists. IAS 1 The best and proven breached loan accounting
As the future covenant test is based on the financial condition of the borrower at a date after the reporting period, the loan should be classified as non-current. This is consistent with our guidance above on covenant tests within twelve months. IAS 1 The best and proven breached loan accounting
If the lender provides a waiver after the reporting date, the borrower classifies the liability as current because at the reporting date it did not have an unconditional right to defer settlement for at least twelve months after the reporting date (IAS 1 74). The grant of the waiver is disclosed as a non-adjusting event (IAS 1 76(c)).
Uncertainty as to whether a covenant has been breached
It is not appropriate to conclude without further analysis that current classification is required simply because a covenant is expressed in qualitative terms and not (for example) as a quantified financial measure or formula. The terms of loan covenants are sometimes expressed in a way that requires interpretation or judgement. For example, a covenant may refer to ‘a material adverse change in the circumstances of the borrower’. The determination of whether or not a breach has occurred at the reporting date may then require clarification from the lender or legal advice. However, the covenant does not of itself imply that the borrower does not have an unconditional right to defer settlement for at least twelve months after the reporting period.
In some cases, the terms of a covenant may suggest that the lender has absolute discretion to judge whether a breach has occurred. In this situation, the substance of the covenant is that of a demand feature with the effect that current classification is appropriate. IAS 1 The best and proven breached loan accounting
IFRS 7 Financial Instruments: Disclosures requires the following disclosures in respect of breaches of loan covenants during the period (unless the breaches were remedied or the terms of the loan renegotiated on or before the reporting date): IAS 1 The best and proven breached loan accounting
- details of the breaches; IAS 1 The best and proven breached loan accounting
- the carrying amount of the loans concerned; and IAS 1 The best and proven breached loan accounting
- whether the breach was rectified or the terms of the loan renegotiated before the financial statements were authorised for issue (IFRS 7 18-19).
Where the borrower breaches a loan covenant after the reporting period and before the date when the financial statements are authorised for issue, this will be treated as a non-adjusting event and the loan will continue to be classified as non current. The breach would be disclosed in accordance with IAS 10 21. IAS 1 The best and proven breached loan accounting
Breaches of loan covenants that are not rectified prior to the date the financial statements are authorised for issue will often have implications for the appropriateness of the going concern assumption which will need to be carefully considered. A detailed discussion of going concern issues is outside the scope of this hot topic. However, it should be noted that:
- Breach of a loan covenant is likely to be associated with wider problems in the borrower’s financial performance and position.
- The possible effect of the breach in accelerating the required repayment of a loan may of itself give rise to uncertainties as to the ability of the borrower to continue as a going concern, in addition to the wider problems referred to above. IAS 1 The best and proven breached loan accounting
- If the impact of a post-reporting date covenant breach (combined with other factors as applicable) is that the going concern assumption is no longer appropriate, the effect is so pervasive that IAS 10 requires that the financial statements are prepared on a non-going concern basis (described in IAS 10 15 as ‘a fundamental change in the basis of accounting, rather than an adjustment to the amounts recognized within the original basis of accounting’). IAS 1 The best and proven breached loan accounting
- IAS 1 25 specifies disclosures concerning material uncertainties as to an entity’s ability to continue as a going concern. Information received after the reporting date (including a covenant breach) is relevant in assessing whether these disclosures are required (IAS 10 16). IAS 1 The best and proven breached loan accounting
Example 1 – covenant test within 12 months
Entity A has a long term bank loan which is subject to certain financial covenants. The loan agreement states that these covenants will be assessed at the end of each quarter, and reported to the bank within a month of the end of each quarter. If the covenants are breached at this time, the loan will be repayable immediately. At the year end, Entity A determines that it is not in breach of the covenant. IAS 1 The best and proven breached loan accounting
Entity A should classify the loan as non current at the reporting date. The fact that Entity A must assess compliance with the covenants within the next twelve months does not change the condition of the loan at the reporting date. This assessment relates to future conditions.
Example 2 – probable future covenant breach
Facts as in example 1 except Entity A believes that it is likely that there will be a breach in the following quarter.
Entity A should classify the loan as non current at the reporting date. The fact a future breach is likely does not change the condition of the loan at the reporting date. IAS 1 The best and proven breached loan accounting
Example 3 – covenant breach and waiver
Facts are as in example 1. Prior to the reporting date, Entity A breaches a covenant and obtains a waiver from the bank. The terms of the waiver specify that Entity A has twelve months from the reporting date in which to rectify the breach and the bank cannot demand repayment as a result of the breach during this period. Entity A expects to rectify the covenant breach by raising additional equity capital by means of a rights issue to existing shareholders. The rights issue has been fully subscribed.
Classify the loan as non current at the reporting date, Entity A had obtained an appropriate waiver in respect of the breach before the reporting date and it is within its power to rectify the breach within the waiver period. IAS 1 The best and proven breached loan accounting
Example 4 – covenant breach and limited period waiver
Facts are as in example 3 except that the terms of the waiver specify that the bank cannot demand repayment as a result of the breach during the next three months in which period it will enter into discussions with Entity A in respect of a refinancing of the loan. IAS 1 The best and proven breached loan accounting
Entity A should classify the loan as current at the reporting date. The loan was in breach at the reporting date and the waiver does not excuse the breach. The bank has deferred a decision regarding the repayment of the loan for a period of less than twelve months from the reporting date. IAS 1 The best and proven breached loan accounting
Q – What is the difference between a positive and a negative debt covenant? IAS 1 The best and proven breached loan accounting
A negative covenant is restrictive. For example, a company is told it cannot take additional debt. Whereas a positive covenant is an obligation to do something. For instance, a lender might ask a borrower to retain a cash balance equivalent to a percentage of the outstanding balance. IAS 1 The best and proven breached loan accounting
Q – Why do lenders use covenants in lending agreements?
Lenders use covenants to keep borrowers within a certain level of risk. Covenants help lenders to monitor loans. In particular, a lender can see if a borrower is keeping on track with forecasts and is spending its money as intended. Elsewhere, covenants act as an early warning signal of a company getting into trouble.
Q – Are covenants similar/different to securities?
Securities will take the form of pledge against the company assets. If a company is put into Administration, a lender can get its money back by realising or selling its securities. On the other hand, covenants are used to monitor loans. Contractually speaking a lender can “recall” a loan if a covenant is triggered. However, if a breach is periodic, lenders tend to work with the borrower to resolve the issue.
Q – Why is this topic important for tech companies?
It’s essential for all companies to understand covenants. However, it’s probably more critical for high growth businesses, which tend to be tech companies. The reason being is that traditional more mature businesses tend to be stable in terms of business model, revenue, profit etc., whereas tech companies are on a slightly less linear path. This path can lead to breaching covenants.
Q – Why do tech companies worry about covenants?
Tech companies invest heavily in Intellectual Property (IP), so when a lender becomes the senior creditor in the event of a default, this poses a significant problem. However, the level of ‘worry’ can be managed by understanding the risks and mitigations.
Q – What happens when debt covenants are violated?
When a covenant is breached, a lender has the right to recall its loan (ask for full repayment) and push a borrower into Administration. Clearly, it’s not in a lender’s interests to take such drastic action. So unless a company is in significant distress and is unlikely to be saved, lenders work with management to see how and when they can get a company back on track.
Q – Do private debt funds issue covenants?
Some do, and some don’t
Q – How is it that the covenants issued by private debt funds are ‘lighter’ than those issued by conventional debt financiers?
It all comes down to underwriting. Whereas bank lenders cannot see finance opportunities outside of traditional net debt EBITDA ratios, a private debt fund is likely to have specialisms in the tech sector and more importantly understand your business model. Because of its understanding, it underwrites on the quality of your business plan, revenue streams, and capital strategy. And unlike asset-based finance which secures loans on collateral in the form of fixed assets, a private debt fund can leverage your intellectual property assets as security.
Q – How did private debt fund finance come to be?
There is a long history. But it came to fore after the financial crisis, when the banks stopped lending. Non-bank institutions set up to fill the gap.
Q – What types of companies are eligible for private debt funded finance?
Private debt funds will consider all companies for debt finance.
Q – How do tech companies benefit from a private debt fund approach to underwriting debt finance deals?
It’s simple. Conventional banks can’t support growing tech businesses. And debt is cheaper than equity. Because private debt funds understand the tech business model, they’re ideally placed to help tech companies boost cash reserves to extend their cash runways. Also to support growth when a tech company has a roadmap for profitability but isn’t ready to raise funds in a further equity round.
See also: The IFRS Foundation