Report on Impact of IFRS 16 Leases on Financial Covenants in Loan Agreements

On December 9, 2015, the European Financial Reporting Advisory Group (EFRAG) published a feedback report relating to a public survey undertaken by EFRAG and others in July 2015 aiming to understand the effects of the introduction of IFRS 16 Leases on financial covenants in loan agreements.

IFRS 16 Leases is expected to be issued and be effective from early 2016 and requires that all identified leases, including operating leases, be identified on a lessee’s balance sheet (with only limited exceptions).

Loan agreements may include financial covenants that require borrowers and other obligors to meet specified ratios based on information from their accounts and financial statements. It is understood that, by recognizing operating lease commitments as lease liabilities, this may adversely affect financial covenants and cause entities to breach those covenants.

However, loan agreements may be drafted to mitigate the impact, for example by using “frozen GAAP” language (restricting the GAAP basis for the underlying accounting data to that which existed at the date of signing) or allowing the renegotiation of covenants when accounting standards change.

The report states that a majority of lender respondents indicated their loans included such mitigating provisions in which case IFRS 16 was not expected to cause a breach of covenants. However, responses from both lenders and non-lenders suggest that the adoption of IFRS 16 will  mean that some lenders and their customers may need to renegotiate financial covenant ratios and either change their approach for future agreements or adjust the level of their ratios after IFRS 16 is introduced.

The report also noted non–lenders’ concerns that lenders could use the introduction of IFRS 16 as an opportunity to renegotiate covenants in their favor and the suggestion that a longer period (3 to 5 years) be allowed before the effective date of IFRS 16, to allow sufficient time for “a natural churn of renewing bank facilities”, including covenants, on the new basis.

The results of the survey will not have a direct impact on the issue of the new accounting standards but are a useful reminder for lenders, their customers and their advisers to consider the impact of the new standards on the financial covenants in their loan agreements.