UK: Accounting Changes Give Legal Headache for Borrowers and Lenders

Last Updated: 21 July 2003

From 1st January 2005 – a fast-approaching deadline – all companies listed on regulated Stock Exchanges in the EU (listed companies) will be required to follow International Financial Reporting Standards (IFRSs) in their group financial statements. This will potentially have a major impact on companies’ legal documents relating to borrowings as they will have to refer to international standards instead of UK Generally Accepted Accounting Practice (GAAP).

Some companies will face higher gearing in their balance sheets, as well as much greater volatility in their earnings (EBIT, EBITDA) and net asset numbers (tangible net worth). These are figures that have traditionally been used as the basis of financial covenants and borrowing limits for companies, and which commonly use UK GAAP and the Companies Act format for accounts as a fundamental reference point.

The major areas of change

Although in many ways UK standards are similar to IFRSs, there are some major differences, and some new developments are expected before and just after 2005.

  • Perhaps the most significant change we will see in 2005 is that many financial instruments, including derivatives such as options and futures, will have to be shown at fair (usually market) value on company balance sheets, which will introduce substantial volatility into financial statements. In many cases the changes in value from one year to the next will be reported against profits, affecting earnings figures. They may come within the definition of "Borrowings" in your covenants.
  • Something we may see even sooner than 2005 (as the UK Accounting Standards Board may adopt it in 2004) is a standard that requires the full fair value of shares and share options awarded to directors and employees to be taken against profits. For some companies this could depress earnings significantly; the average impact on UK companies has been quoted at anywhere between 5% and 15% of earnings.
  • Because the EU Regulation on IFRS overrides the Accounting Directives, and hence company law in relation to company accounts, the standard Companies Act formats we are used to seeing in the UK for both the balance sheet and profit and loss account will disappear. Instead, the relevant international standard will apply, but this simply lists out the items to be shown in the accounts without giving a specific format. New terminology will have to be used to identify the relevant items in the accounts for the purpose of precisely defining your financial covenants.
  • In any case, probably from 2006, there will be a new and completely revamped comprehensive income statement, replacing the profit and loss account as we know it.
  • Also from 2006, there will be a revised international standard on pension costs, probably similar to the UK’s FRS 17, which has proved so controversial. Surpluses and deficits will come onto company balance sheets, thus affecting net worth; operating profit and interest payable will also be affected.

All this may also apply to unlisted companies’ individual and group accounts, depending on whether the Department of Trade and Industry decides to require all companies to follow IFRS (although possibly with a later deadline). A decision from the DTI is imminent.

Should you be concerned?

  • Are you a listed company? Do you have debt facilities which include financial covenants outstanding through to 2005?
  • Or do you have term options or renewals likely to take you through into 2005?
  • Do you have borrowing limits in your articles?

The real risk for companies is that they may breach financial covenants or borrowing limits simply due to market movements because so many new fair values are coming into financial statements.

The extent to which your company is affected by the move to international standards will depend on its industry and the characteristics of your business. Companies most severely affected will be heavy users of derivative financial instruments and those with defined benefit pension schemes, but companies in all sectors will be affected to some extent.

What should you do now?

It is important to identify, as early as possible, any potential problems with financial covenants or borrowing limits arising from the switch to IFRSs:

  • Are you considering taking out or renewing banking facilities before 2005?
  • Do you have renegotiation or reconciliation clauses for new accounting standards in your existing facilities?
  • Do you need to speak to your major investors about changing the borrowing limits in your articles?
  • Do you need to go through an exercise to reset your financial covenants?

Your accounts function may be busy working towards the implementation of international standards, but not all the implications will yet have been considered. However, it is important not to wait until all the accounting changes have actually been made in 2005 before acting on related borrowing limit issues – that will almost certainly prove to be far too late.

Article by Clive Barnard, Kathryn Cearns and Ewen Fergusson

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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