How the FRS 102 amendments could affect loan covenants

In a previous article, we explored the key changes to UK GAAP and how they might affect your business.

For businesses with borrowing arrangements, one area deserves particular attention: loan covenants.

Changes introduced through the FRS 102 amendments may alter the financial metrics used in covenant calculations, including EBITDA, net assets and gearing (the level of debt relative to equity). As a result, some businesses could find themselves closer to a covenant breach, or in breach, despite no change in their underlying trading performance.

Why loan covenants may be affected

Loan covenants are typically based on financial ratios calculated using figures reported in the financial statements. When accounting standards change, the figures used in those calculations may also change, sometimes significantly.

As a result:

• A business could appear to breach a financial covenant, even if trading performance has remained unchanged.
• Headroom against covenant limits may reduce significantly.
• Management teams may need to engage with lenders earlier than expected.
• Other arrangements linked to financial metrics, such as management incentives or employee bonus schemes, may also be affected.

Businesses should not assume that all loan agreements will address to the FRS 102 amendments in the same way. Some agreements contain provisions that adjust covenant calculations to neutralise the effect of future accounting standard changes. These are often referred to as ‘frozen GAAP’ provisions.

Where such provisions exist, the impact of the FRS 102 amendments on covenant calculations may be reduced or eliminated. Businesses should review the specific terms of their borrowing arrangements and take advice where the wording is unclear.

The balance sheet impact of a covenant breach

One of the most important consequences of a covenant breach is the potential effect on how borrowings are presented on the balance sheet.

In many cases, a covenant breach that occurs on or before the reporting date can result in a loan becoming repayable on demand. Where this happens, the borrowing may need to be shown as due within one year, even if the lender has no intention of demanding repayment.

This can have wider consequences, including:

• A weaker reported liquidity position,
• Increased scrutiny from lenders, investors and other stakeholders, and
• The possibility of triggering other contractual arrangements that depend on reported financial information.

Why timing matters when seeking a waiver

Where a covenant breach is anticipated, or has already occurred, timing is critical.

If a waiver or grace period is agreed before the reporting date and gives the business the right to defer repayment for more than 12 months, the borrowing may continue to be shown as due after one year.

However, if the waiver is obtained after the reporting date, it will generally not change the classification of the borrowing in that period’s financial statements. Businesses should therefore engage with lenders early and shouldn’t assume that a waiver secured after the year-end will resolve any balance sheet presentation issues.

The existence of a waiver doesn’t automatically resolve the issue. Whether a borrowing can continue to be presented as due after one year depends on the legal substance of the waiver and the terms of the underlying loan agreement. The key question is whether the arrangements give the business an unconditional right to defer repayment for at least 12 months after the reporting date.

In some cases, legal advice may be needed to understand the implications of the lender’s concessions and the terms of the loan agreement.

What businesses should do now

Businesses with borrowing arrangements should take proactive steps ahead of their first reporting period under the amended FRS 102. Early planning can help identify potential issues, avoid unexpected covenant breaches and provide sufficient time to discuss any concerns with lenders.

Assess the impact

• Review how changes to revenue recognition and lease accounting could affect the financial statements.
• Identify which financial measures are used in loan covenant calculations and whether those measures may change under the amended accounting requirements.
• Consider whether any changes could affect compliance with existing borrowing arrangements.

Model covenant outcomes

• Recalculate financial covenants using figures prepared under the amended accounting requirements.
• Assess whether there is a risk of covenant breaches or reduced covenant headroom.
• Identify potential issues as early as possible so that appropriate action can be taken.

Engage with lenders early

• Discuss potential impacts of the accounting changes with lenders before any issues arise.
• Consider whether covenant calculations, loan agreements or waivers may need to be amended.
• Ensure any agreed amendments or waivers are formally documented before the reporting date where necessary.

Keep clear records

• Monitor covenant compliance throughout the year.
• Maintain clear documentation of covenant calculations and discussions with lenders.
• Seek advice where the impact of the accounting changes, or the terms of a waiver, are unclear.

How Saffery can help

Although the FRS 102 amendments are accounting changes, their impact may extend well beyond financial reporting.

Businesses with borrowing arrangements should assess the potential impact early, engage with lenders where necessary and ensure that any covenant implications are fully understood before the amendments take effect.

If you’d like to discuss how the FRS 102 amendments could affect your business or your financing arrangements, please get in touch with Anna Hicks.