Columnists
Understand the reporting impact of restrictive covenants
Monday, October 31, 2022
Financial institutions often include borrowing covenants in their loan agreements. PICTURES | SHUTTER
Organizations usually enter into loan agreements when they borrow from financial institutions. Financial institutions often include borrowing covenants in their loan agreements.
In summary, covenants are predefined conditions to be met by the borrower in a loan agreement. They include financial ratios such as liquidity, solvency, interest coverage and total assets to debt. These ratios are included in loan agreements by lenders to ensure repayment of their loans in accordance with the loan agreement.
Any breach of these financial ratios by an organization often results in a loan that would otherwise be long-term in nature, becoming immediately repayable. This is because the lender has the legal right to demand repayment. In addition, the borrower does not have the unconditional right to defer payment for at least 12 months after the end of the reporting period.
This implies that these borrowings will be reclassified from non-current liabilities to current liabilities on the balance sheet due to non-compliance with borrowing covenants. Indeed, although the loan is not repayable within 12 months of the end of the reporting period, it can be reclaimed by the lender at any time without reason following a breach of a covenant.
Organizations need to understand the reporting implications, available remedial actions, and their timing to avoid adverse effects of covenant breaches on their financial statements.
Organizations should be clear about the covenant testing date referenced in their loan agreement and ensure they are monitoring compliance taking into account their reporting period.
They must pay attention to the various complexities of these arrangements. For example, organizations should consider the impact of a grace period that allows the borrower to rectify a breach of covenant that results in immediate repayment of the loan.
Organizations should consider the impact of other waivers granted by lenders as a result of covenant breaches and their timing. If an organization breaches a borrowing covenant after the reporting date, the borrowing is a non-current liability on the balance sheet.
The author is a managing partner at PwC Kenya. He writes and gives numerous speeches on corporate reporting.