Financial Covenants and Financial Reporting

With the impact of covid 19 on the full spectrum of an entity’s stakeholders being an ever changing feast, many businesses are still experiencing high levels of uncertainty around their performance and the future which could result in financial covenants being breached.

FRS 102 requires narrative disclosure of defaults on loans payable meaning that it is in an entity’s best interest to engage early with its lenders to ensure that any issues are resolved ahead of the end of the reporting period as far as is possible.

What disclosure is required?

If during the reporting period there has been a breach of the terms of a lending agreement or a default of principle, interest, sinking fund or redemption AND this has not been remedied by the reporting date the accounts will require a narrative disclosure, comprising:

· details of the breach or default,

· the carrying amount of the loan in default at the reporting date and

· whether the breach or default was remedied or the terms of the loan renegotiated before the financial statements have been authorised for issue.

What about presentation?

The occurrence of a breach or default may also result in a change to the presentation of the loan within the balance sheet. Where the loan becomes due on demand as a result of the breach or default, the loan will need to be reclassified as a current rather than a long term liability. This means that the loan would no longer be presented within creditors due in more than one year but would instead be presented within creditors due within one year. This could have a negative impact on the credit rating of the business and impact the availability of sources of finance or the cost of that finance in the future.

Are there any other impacts?

Any renegotiation of loan terms within the reporting period will need to be considered as to whether or not the renegotiation amounts to a substantial modification.

Where a borrower and a lender substantially modify the terms of a loan, the old loan should be derecognised (removed from the financial statements) and the new financial liability recognised (included in the financial statements).

What is considered a substantial modification?

In making the assessment as to whether or not there has been a substantial modification to a loan both qualitative factors and quantitative factors, should be considered. Qualitative factors would be those such as the currency in which a loan is to be repaid and a quantitative factor would be the difference in net present value of the cashflows of both loans. Where this change in circumstance would alter the opinion of the users of the financial statements or the change in value is material this would be considered substantial.

Where there is a substantial modification the costs involved in the renegotiations will need to be carefully analysed as those which are directly related to the new debt as these will need to be capitalised and deducted from the amount of the loan, and those which are not directly related as they will need to be expensed. Where the renegotiation of terms is not considered to be substantial all associated costs would be expensed to the profit and loss.

My business is small, does the above still apply?

For small businesses applying FRS 102 section 1A there is no requirement to disclose breaches of covenants, however the standard does require anything that is needed for a true and fair view of the financial statements to be disclosed.

This will require judgement as to whether or not the narrative disclosure above would be required, although elements impacting the presentation and recognition and derecognition would still apply.

Where an entity is reliant on the lending arrangement for the continuation of its business, or the renegotiation includes values which are material to the financial statements then the narrative disclosure would be likely.

What is my business is a micro entity?

For micro entities applying FRS 105 there are not any requirements to disclose breaches of covenants. The only impact on the financial statements would be that of presentation.

Action to be taken

We strongly advise that all entities get in touch with their finance providers as soon as they become aware of the possibility of a breach or default as this will start the process of remedial action and may avoid the need for disclosure in the financial statements if the remedy is complete ahead of the reporting date.

If a breach or default has already occurred, again we recommend contacting your provider of finance sooner rather than later so that renegotiations can be started. Although these negotiations may not be complete ahead of the reporting date the disclosure will be more meaningful and have less of an impact if it is more detailed and certain as to the next steps which will be required.

Contributing to your success

If you would like to discuss the impact of a possible breach of lending terms in your financial statements get in touch with your usual Albert Goodman contact or Sophie Parkhouse direct.