14 April 2020

IFRS 16 and financing arrangements: from frozen GAAP to adjusted covenant levels

With the entry into force of IFRS 16 on 1 January 2019, many companies will have to adhere to a new set of rules when preparing their 2019 and future financial statements. The compulsory adoption of IFRS 16 may significantly affect a company's balance sheet, and its ability to both meet financial covenants and comply with undertakings under existing loan documentation. Companies with significant operating lease obligations, in particular, should consider their existing loan documentation in light of IFRS 16 and, if needed, amend this to cater for the new regime. So far, "frozen GAAP" has been the most frequently used solution, but we increasingly see financial and restrictive covenant levels being adjusted to reflect the new reality.

What has changed?

Under IAS 17, the previous regime, finance leases were treated differently from operating leases (that is, all leases that are not finance leases). The former regime treated finance leases – which are economically similar to a purchase of the underlying asset by generally transferring risks and rewards to the lessee – as debts. In the lessee's balance sheet, the leased asset was included on the asset side, depreciating over time, while the "purchase price" – the obligation to pay rent – was listed as a liability. Operating leases, on the other hand, were not included in the balance sheet at all, and were only disclosed as line items in income statements and notes to the financial statements. IFRS 16 has eliminated the distinction between finance leases and operating leases. It defines a lease as "a contract, or part of a contract, that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration". This new accounting model thus requires lessees to treat operational leases in a similar way to finance leases. This implies that the leased assets should be reported as an asset on the balance sheet, and the lease payment obligation as a liability, with a few exceptions for short-term leases (12 months or less) and leases of low value (USD 5,000 or less). The implementation of IFRS 16 may affect companies with substantial operating lease liabilities. Modifications to several customary financial covenants used in loan documentation include:
  • leverage ratios – although EBITDA may increase as operating lease expenses are no longer included and increasing charges for depreciation and amortisation are excluded, the net debt position may also increase, potentially leading to a higher leverage ratio; and
  • debt-to-equity ratios – operating lease liabilities will increase a company's total liabilities on the balance sheet and could potentially raise the debt-to-equity ratio.
Similarly, other financial covenants may be impacted and may require modification. Apart from the impact on financial covenants, IFRS 16 may also significantly affect loan documentation. For example, general negative undertakings, such as financial indebtedness provisions, may become even more restrictive as they could now also extend to operating leases, potentially leading to non-compliance.

Solutions used in practice

Loan documentation often includes "frozen GAAP" provisions, with covenants continuing to be tested based on relevant accounting standards that applied when the documentation was entered into. Should this be the case, no reset or amendment of financial and other covenants would be required to provide for the changes resulting from IFRS 16. Frozen GAAP was always meant to be a temporary solution, as companies would generally need to prepare two separate sets of financial statements or its auditors would need to provide a reconciliation statement alongside the company accounts. However, practice shows that frozen GAAP is still a widely used approach. This applies equally to new financing arrangements and to amendments of existing agreements. It is, however, uncertain whether accountants will continue to sign off on 'shadow' financials in the future, as they might be unable or unwilling to recognise the distinction between the two types of leases based on IAS 17 and provide their opinion on this. Other, more bespoke solutions include the complete exclusion of both finance and operating leases from loan documentation. This involves amending the relevant documentation to carve out any positive or negative effects of leases on restrictive covenants (such as limitations on financial indebtedness), as well as on the financial covenants.

Going forward

While a temporary solution like frozen GAAP might offer a welcome quick fix, and taking into account that bespoke solutions such as the above may not be available to all borrowers, borrowers should, for a more robust solution, carefully assess the impact of IFRS 16 on their balance sheets and their loan documentation. Potentially, all provisions in the loan documentation that may be affected by the changed treatment of operating leases, may need to be renegotiated and amended. Such amendments may include:
  • remodelling and recalculating the financial covenants, taking the impact of IFRS 16 into account;
  • increasing or decreasing the exceptions (the "permitted" baskets) to the restrictive covenants, keeping in mind that certain baskets – such as for permitted financial indebtedness – could fill up very quickly due to the different treatment of operating leases.
In practice, we note an increasing tendency of borrowers and lenders to discuss and implement these changes when entering into new financing arrangements. This seems to be a logical and more sustainable approach for the long term, as borrowers' financial statements should comply with IFRS 16 anyway and the "frozen GAAP" solution may not be available for much longer. A reset of the financial and restrictive covenant levels reflects this new reality and limits the need for "shadow financials".