Thin capitalisation: practical guidance: accountancy issues: impact of accounting on loan agreements
Existing loans and changes of accounting practice
A third-party loan will be provided under terms that reflect the borrower’s ability to service the debt (unless there is a guarantee in place supporting greater debt or modifying the terms). If there is a change in the way that the borrower prepares its accounts, that does not remove the original basis on which the lending was agreed. This chapter looks at the following particular areas where loan covenants may be affected by accounting practice:
- preference shares which have the substance of debt (FRS25, IAS 32 or FRS 102) - INTM523180.
- pension funds and pension costs (FRS 17, IAS 19, IAS 19 (revised) or FRS 102) - from INTM523210.
As is discussed in the chapter on working thin capitalisation cases (INTM513000 andINTM514000 onwards), a key issue is the borrower’s ability to service debt and make repayments as they fall due. A third-party lender will therefore want assurance that his investment will be safe in the event of the borrower encountering difficulties and will require an adequate equity base.
A borrower’s ability to service debt and make repayments depends on the underlying cash flows of the business. In order to examine these cash flows, adjustments usually have to be made to items reported in the profit and loss account (income statement under IFRS) and to the balance sheet (statement of financial position under IFRS) in order to adjust for the effect of non-cash transactions, for example, accruals, debtors, depreciation, amortisation.
You are advised to contact either a compliance accountant if you require assistance in this area.
Cash flow statements
The underlying cash flows of a business will also be disclosed by its cash flow statement. This statement provide useful information on a borrower’s ability to its service debt, though cash flow based covenants are unusual.
Only some entities are required to prepare a cash flow statement. All entities adopting the IFRS must produce a cash flow statement, but under Current UK GAAP and New UK GAAP some companies are exempt from this requirement if they qualify as either small (as defined by the Companies Act 2006) or are part of a group which prepares publicly-available consolidated accounts containing a consolidated cash flow statement.
UK GAAP companies qualifying for an exemption may, nevertheless, choose to prepare a cash flow statement,
Cash flow statements are considered in the chapter on interest cover covenants, which measure a company’s ability to service its debt obligations, at INTM516000.
If cash flow information is unavailable, a pragmatic approach is to monitor debt using covenants similar to those that a third-party bank would use. In many cases a third-party lender will specify financial covenants to be adopted by the borrower. These include the debt:EBITDA and debt:equity ratios (see INTM517000 onwards), and interest cover (INTM516000 onwards).