Ifrs 16 Impact on Loan Agreements

IFRS 16 Impact on Loan Agreements: What You Need to Know

The International Financial Reporting Standards (IFRS) 16, which came into effect in January 2019, has significantly changed the way companies account for their leases. The new standard has eliminated the distinction between operating leases and finance leases, requiring lessees to recognize all leases on their balance sheet. This change has implications for loan agreements, particularly those with covenants that are based on financial ratios.

Here are some key aspects of IFRS 16 that can impact loan agreements:

1. Debt-to-Equity Ratio

The debt-to-equity ratio is a common covenant in loan agreements that measures a company`s leverage. With the adoption of IFRS 16, the inclusion of lease liabilities on the balance sheet will increase the company`s total debt, potentially breaching the covenant and triggering a default. Companies should review their loan agreements and renegotiate the covenant formula to accommodate the new lease liability.

2. Interest Coverage Ratio

The interest coverage ratio is another covenant that measures a company`s ability to service its debt. The adoption of IFRS 16 may increase the interest expense by recognizing lease payments as interest expense rather than operating expense. This change could negatively affect the ratio, leading to a breach of covenant. Companies should review their loan agreements and renegotiate the covenant formula to exclude the impact of the lease liability on interest expense.

3. Financial Reporting Requirements

The adoption of IFRS 16 requires companies to disclose additional financial information about their leases, such as the lease term, lease payments, and discount rate. Lenders may require companies to provide this information as part of their loan agreement reporting requirements. Companies should ensure they have the necessary systems and processes in place to provide this information to their lenders.

4. Cross-Default and Acceleration Clauses

Loan agreements often contain cross-default and acceleration clauses that allow lenders to trigger a default and demand immediate repayment if a borrower breaches another debt agreement. The adoption of IFRS 16 may increase the likelihood of a cross-default if the lease liability breaches a covenant in another debt agreement. Companies should review their loan agreements to ensure there are no unintended consequences of breaching other debt agreements.

Conclusion

The adoption of IFRS 16 has significant implications for loan agreements, particularly those with financial covenants. Companies should review their loan agreements and consider renegotiating the formulas and reporting requirements to accommodate the new lease accounting standard. Failure to do so could result in a breach of covenant and negatively impact the company`s relationship with its lenders. As a result, both companies and lenders should take steps to fully understand the impact of IFRS 16 and proactively address any potential issues.