The Hindu Business Line : Impact of debt covenants

As per paragraph 74 of the proposed revised AS-1 (which is based on IAS 1), when an entity breaches a covenant of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the entire liability as current.

This is the case even if the lender agreed, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach. This is one of the major differences between existing AS-1 and the proposed AS-1. If a reclassification is triggered by a breach of a debt covenant, such reclassification will impact not only the borrowing entity’s gearing and current ratios but also its reputation, credit rating and regulatory or other norms.

Further, a reclassification of a long-term loan as current due to breach of debt covenant may impact debt covenants of other loans which are otherwise not impacted. In extreme situations, it would affect the entity’s ability to continue as a going concern.

Impact of breach

Most debt arrangements lay down certain conditions/obligations which a borrower needs to comply with, which are generally known as debt covenants. The debt arrangements would also lay down the consequences if the covenants are breached. In some cases, the debt arrangements may lay down different consequences for different types of breaches whereas in other cases, the consequences may be the same irrespective of the type of breach.

The covenants included in the long-term loan arrangements could range from being very significant to relatively insignificant. Significant covenants may include items such as payment of dues on time, implementation of the project for which the loan is taken, utilisation of the loan for the purpose sanctioned, maintenance of adequate security to cover the loan, change in management structure, mergers and amalgamation, restriction on distribution of profits/dividends, restriction on raising loans from other sources, etc.

Relatively insignificant covenants may include items such as submission of financial information on a timely basis, furnishing other information/documents, delay in registering a mortgage or providing adequate insurance coverage, etc.

If an entity fails to comply with one or more of these covenants, the lenders’ right to charge penal interest or seek other compensation, demand immediate repayment of loans, enforce security or require a guarantee for the dues may kick in.

If one of the consequences in the loan arrangement is that the liability becomes payable on demand, then this may trigger a loan reclassification from non-current to current.

Evaluation needed

What needs to be done by the standard setter? In many cases, breaches of debt covenants are excused by lenders and the debt is not recalled though the lender may have that right. Consequently, it would be misleading for standards to require reclassification from non-current to current in the books of the borrower.

The standards should be amended to require an evaluation by the management of whether in substance the lenders are likely to recall the loan. If it is demonstrated that it is unlikely that the lender would demand payment and appropriate evidence to that effect is obtained from the lender, reclassification should not be triggered, even if that evidence is gathered after the end of the reporting period. In such cases, a disclosure in the financial statements of the breach may be sufficient.

Onus on borrowers

What needs to be done by the entity if the standard is not amended? A borrowing entity should carefully examine its loan arrangements and ensure that for minor breaches, the lender should not have the right to demand repayment of the loan.

The borrowing entity should, on a regular basis, ensure compliance with the covenants and where there are breaches, approach the lender to condone them before the end of the reporting period.

An inadvertent slip could result in a breach of covenant and could trigger the loan being classified from non-current to current. To cite an example, a loan arrangement may prohibit an entity from taking another loan without the permission of the lender. An entity that borrowed money from a group company by way of short-term inter-corporate deposit may have inadvertently breached the covenant. Borrowing entities should be careful about these situations, otherwise the consequences could be damaging on the financial statements.

India is adopting International Financial Reporting Standards (IFRS) in 2011. Hence, borrowing entities can no longer afford to ignore the fine print in debt arrangements. Also, standard setters need to look at the standards and make them more practicable.

(The author is Partner & National Leader IFRS, Ernst & Young.)