Understanding the reporting impact of borrowing covenants

Financial institutions often include borrowing covenants in their loan contracts. PHOTO | SHUTTERSTOCK

By Akinyemi Awodumila  More by this Author

Organisations usually enter into lending agreements when they borrow from financial institutions. Financial institutions often include borrowing covenants in their loan contracts.

In summary, borrowing covenants are predefined conditions to be met by the borrower as part of a lending agreement. They include financial ratios such as liquidity, solvency, interest coverage, and total assets to debt ratios. These ratios are included in lending arrangements by lenders to ensure repayment of their loans in accordance with the lending agreement.

Any breach of these financial ratios by an organisation often results in a borrowing that would otherwise be long-term in nature, becoming immediately repayable. It is because the lender has the legal right to demand repayment. In addition, the borrower does not have the unconditional right to defer its settlement for at least 12 months after the end of the reporting period.

It implies that such borrowing will be reclassified from non-current to current liability on the balance sheet due to non-compliance with the borrowing covenants. It is because, though the borrowing is not due for repayment within 12 months of the end of the reporting period, it can be called by the lender at any time without cause following a breach of covenant.

Organisations should understand the reporting consequences, remediations available and their timing to avoid the adverse effects of these covenant breaches on their financial statements.

Organisations should be clear on the covenant testing date referenced in their lending agreement and ensure that they monitor compliance considering their reporting period.

They should watch out for various complexities within these arrangements. For example, organisations should consider the impact of a period of grace that enables the borrower to rectify the breach of a covenant that results in the borrowing being repayable immediately.

Organisations should consider the impact of other waivers provided by lenders following covenant breaches and their timing. If an organisation breaches a borrowing covenant after the reporting date, the borrowing is a non-current liability on the balance sheet.

The writer is an Associate Director at PwC Kenya. He writes and speaks widely on corporate reporting.