As 2010 draws to a close, Canadian publicly listed enterprises are busy preparing for a change to their accounting reporting standards. Those companies with fiscal years commencing January 1, 2011 will be required to adopt International Financial Reporting Standards (IFRS) instead of using Canadian Generally Accepted Accounting Principles (GAAP). A great deal of time and energy has been spent by companies in assembling the resources, developing systems and educating stakeholders on the impact of IFRS on their financial position. Many companies have disclosed their strategy in general terms through the management discussion and analysis (MD&A). However, few MD&A's have provided specifics on the actual numerical impact that IFRS may have.
Among the key stakeholders for a company are its debt providers, be they financial institutions, noteholders or other market participants. These lenders have generally provided in their credit agreements or indentures that the company's financial statements must be prepared in accordance with GAAP, as it may change from time to time. It is clear that with the change on January 1st financial statements will effectively need to be prepared in accordance with IFRS. Less clear however is the potential impact that the adoption of IFRS will have on any financial covenants and ratios that exist in a company's debt agreements.
In anticipation of this change, language began appearing in debt agreements1 that allowed the parties to notify each other if the adoption of IFRS resulted in a materially different calculation for a financial covenant. If that result occurred, the parties would negotiate in good faith so that the change to IFRS would be equitably reflected. Effectively though, this has delayed a company's determination of compliance with financial covenants under IFRS until the preparation of their Q1 compliance certificates. This delay along with the shortage of publicly available details has made it challenging for lenders to analyze the potential impact of IFRS on a company, and whether one of their financial covenants could possibly be breached.
We anticipate that IFRS will have the greatest impact (and greatest need for "good faith negotiations") on the calculations of:
Debt to Equity Ratio. IFRS permits companies to elect to value their property, plant and equipment at fair value as opposed to historical cost. If this election is made, one would typically expect an increase in this ratio as a result of the increase in the value of assets.
Debt to EBITDA Ratio. Under IFRS certain assets may be captured on a company's balance sheet that were not seen with GAAP. For example, unlike GAAP's bright line test for the treatment of leases, IFRS' more subjective approach is likely to see more leases characterized as finance (capital) leases. This will result in an increase in assets and a corresponding increase in debt. The calculation of EBITDA may be also affected. Repair and maintenance costs have typically been expensed under GAAP, but IFRS capitalizes certain of these costs and allows the company to depreciate them over time. As a result one may expect increased EBITDA under IFRS as compared with GAAP, and a lower Debt to EBITDA Ratio.
Interest Coverage Ratio. Because IFRS requires interest to be capitalized on certain capital projects, all things being equal, interest expense may decrease and impact this ratio. We expect that this will have more impact on companies with many projects, which under GAAP did not have to include borrowing costs in the cost of the project. However, most lending agreements have defined interest to include amounts capitalized and in those cases the impact will be muted.
Debt to Capitalization Ratio. IFRS requires impairments charges for long-lived assets and goodwill to be measured based on cash-generating units (CGU's) as opposed to asset groups. If a company has many CGU's, it is more likely that its impairment charges will be more frequent and/or higher. IFRS also requires that impairments be reversed if the factor that led to the impairment reverses, with the exception of goodwill. Goodwill impairments are permanent. The adoption of IFRS would seem to cause more volatility of impairments that in turn may cause a company's capitalization to be more variable. Similarly items that were considered as equity under GAAP (eg. foreign currency convertible bonds or warrants) may now be recorded as a derivatives liability and then marked to market. Experts also predict that for more complex organizations, the way they classify their joint ventures and investments in affiliates may trigger swings in their equity.
Underlying the calculations of these financial covenants is a perception that IFRS, with a greater number of policy elections, will result in more subjective determinations than under GAAP. Analysis may be more complicated because different companies in the same industry could make different determinations. It may be harder then to make comparisons between companies as it will be difficult to pinpoint whether a difference is due to their relative performance or their characterization of certain items. Ironically, this subjectivity seems to undercut one of the stated goals of the adoption of IFRS, namely the ability for investors in other jurisdictions to accurately compare the financial information of Canadian companies against similar companies elsewhere.
Nevertheless the age of IFRS is upon us. Affected companies should communicate frequently with their lenders and present draft calculations if necessary. This will lessen the likelihood that a difference of opinion could result in a breach of covenant and ensure a smooth transition to the new standards. We do expect though that 2011 will bring an increased number of requests for amendments as companies and lenders work out the details of the effect of IFRS on financial covenants and their components.
1. Language was much more prevalent in credit agreements because of the relatively less onerous job of amending them as compared with seeking concessions in indentures from institutional investors.
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