Background
The International Accounting Standards Board has introduced a new lease accounting standard named IFRS 16 Leases (“IFRS16”). IFRS16 will come into force from 1 January 2019, unless a company adopts IFRS16 early.
IFRS16 will impact lessees (ie borrowers). It will remove the distinction between finance leases and most operating leases on a borrower’s balance sheet.
Following implementation, borrowers’ recorded debt levels may rise. This may cause the borrower to breach financial covenants and other facility agreement provisions relating to financial indebtedness, potentially triggering Events of Default. Borrowers with many operating leases will be most heavily affected.
Lenders and borrowers need to know about the upcoming changes, identify those that might be affected and consider how best to deal with the impacts.
What potential breaches could arise?
The impact will depend on the specific provisions of each facility agreement.
However, IFRS16 is likely to affect provisions relating to borrower debt levels. These include the financial covenants, restrictions on indebtedness and potentially cross default provisions.
Under the restrictions on indebtedness, any increase in borrower debt levels could cause an Event of Default to be triggered.
IFRS16 could also cause an Event of Default by the borrower breaching the financial covenants. Note that where "look forward" covenants are included in facility agreements, breaches could be triggered ahead of the implementation date of 1 January 2019.
Whether there could be potential breaches of the financial convents will depend on whether the financial covenants rely on “frozen GAAP” or “floating GAAP”.
Under “frozen GAAP”, financial covenants are measured using the set of accounting standards in force when the facility is entered into for the length of the facility. Under this approach, IFRS16 should not result in a breach of financial covenants. However, the borrower’s accountants will have to produce two sets of financial statements.
Under “floating GAAP”, financial covenants are measured using the accounting standards in force on a test date. Under this approach, IFRRS16 could lead to breaches of financial covenants and the bank should run through these scenarios with affected borrowers as soon as possible.
Practical steps
Review our flowchart of simple steps both parties can take to determine whether their financing arrangements might be affected by IFRS16.