Impact of IFRS on Credit Agreements
In our last issue, in anticipation of the adoption of International Financial Reporting Standards (IFRS) on January 1, 2011, we provided practical tips for publicly listed enterprises. In this issue, we discuss how the adoption of IFRS might have an impact on contracts that require a party to comply with Canadian generally accepted accounting principles (GAAP) or, more significantly, that require a party to meet financial tests that depend on financial information prepared in accordance with GAAP. These circumstances often arise in credit agreements.
It is important to note that GAAP will continue to exist after January 1, 2011 and that it will still be appropriate to refer to GAAP in agreements. What will happen on that date is that the Canadian Accounting Standards Board will adopt IFRS, but in that modified form it will still be GAAP. As a result, if the only requirement in an agreement is that a party maintain financial statements in accordance with GAAP, the adoption of IFRS will have no impact. However, if, as is often the case, an agreement contains financial tests, the adoption of IFRS may have a considerable impact. For example:
- Balance sheet restatements. Under IFRS, companies can elect to show assets at fair market value rather than at cost. For capital assets such as real estate, this can have a large impact. These kinds of changes will affect balance sheet financial covenants, such as debt-to-equity ratios.
- Potential for more earnings volatility. Assets shown at fair market value rather than cost will also impact the income statement. As fair market value fluctuates over time, gains and losses are to be reflected on the income statement. Although of a non-cash nature, this may have an impact on how cash flow financial covenants (such as Debt to EBITDA) will be drafted.
- Asset recognition. Adoption of IFRS may result in assets being recognized on financial statements that had not previously been recognized, which in turn may result in an impact on current ratios or quick-asset ratios. For instance, many capital leases are not recognized on the balance sheet using GAAP. With IFRS, there is greater potential for capital leases to appear on the balance sheet, thereby increasing total assets.
Companies will be collecting data this year so that they can provide IFRS-compliant comparative figures with their first required IFRS financial statements in 2011. As such, they will have made or will be making assessments on how IFRS will apply to the company, and on which accounting policies will be used. With this information in hand, companies should take the time this year to review the effect of these adjustments on their credit agreements.
Any credit agreement entered into that contains financial tests and that will be in existence after January 1, 2011 should anticipate the accounting changes that the adoption of IFRS will effect.