The Impact of the Change to International Accounting Standards on Debt Covenants: A UK Perspective1

1. Thanks are due to Judy Day for comments on earlier drafts of this paper.

Abstract

This paper examines the impact on covenants in the debt contracts of companies of the impending change to international accounting standards (IAS). The primary focus of the paper is the UK debt market, but comparisons are drawn with other EU countries that will also be affected by the adoption of IAS. Existing evidence of the nature of debt covenants and the impact of accounting regulation change on such covenants is briefly reviewed. It is argued that the adoption of IAS will have a significant impact both on reported earnings and on balance sheet values. Moreover, it is argued that the adoption of IAS will increase the volatility of earnings. It is further argued that, as a consequence of these effects, there will be a significant impact on debt covenants given the widespread use of rolling GAAP. A number of cases and hypothetical examples are provided to illustrate the impact of the adoption of IAS.

Notes

1. Thanks are due to Judy Day for comments on earlier drafts of this paper.

2. Hereafter for ease of exposition ‘IASs’ will be taken to include both International Accounting Standards and International Financial Reporting Standards when general reference is made to both. Otherwise IAS and IFRS will be used as appropriate to the context of the argument.

3. Technical breaches of covenants are distinguished from cash flow breaches. The latter arise if interest or principal payments are not made by borrowers.

4. For Australia see Cotter (1998), for South Africa see Malherbe and Segal (2001), for Malaysia and Singapore see Roubi and Richardson (1998).

5. Covenants restricting dividends are also rare in Germany (see Leuz et al., 1998).

6. The possible reactions of borrowers range from ignoring the breach, through issuing an automatic waiver, discussions with the borrower on the violation, changing the status of the loan for monitoring purposes, renegotiating tighter terms for the contract, demanding accelerated repayment, forcing asset sales to raise cash or seizing collateral, requiring refinancing or reorganization, or initiating insolvency proceedings. Where a firm has multiple borrowings cross-default clauses may be activated.

7. As Zeff (1978) argued: ‘The [Financial Accounting Standards] Board is thus faced with a dilemma which requires a delicate balancing of accounting and non-accounting variables. Although its decisions should rest – and be seen to rest – chiefly on accounting considerations, it must also study – and be seen to study – the possible adverse economic and social consequences of its proposed actions’ (italics added).

8. Recent research on small and medium-sized enterprises indicates that covenants involving working capital (expressed as debentures collateralizing overdrafts) are extremely common in the UK (see Day and Taylor, 2001). These covenants appear to be such a common feature of UK debt contracts that it is likely that many companies large enough to be subject to IASs will be affected.

9. For example, for an entity switching to IFRSs for the year ending 31 December 2005 the date of transition to IFRSs is 1 January 2004.