Disclosure in the IFRS financial statements in the event of a (potential) breach of loan covenants within twelve months after the end of the reporting period

Objective

The FSMA summarizes hereafter its expectations regarding the information that should be included in the notes to IFRS financial statements concerning (potential) breaches of covenants relating to loan arrangements. 

Basic principle 

It is essential that information disclosed in IFRS financial statements enable their users to gain insight into the risk (including the likelihood) of a breach of covenants and into the impact associated with (potential) breaches. 

Expectations 

Under IFRS, certain liabilities can be classified as non-current, while the right to defer their settlement beyond twelve months after the reporting period depends on compliance with covenants that must be met after the end of the reporting period. In such a case, an issuer must provide in the notes disclosures that enable users of the financial statements to understand the risk (including the likelihood) that the aforementioned liabilities could become repayable within twelve months after the reporting period, as well as the underlying impact.

To this end, the FSMA expects issuers to provide information on: 

1. the covenants, including
   1. their nature. In this regard, the FSMA expects issuers to provide clear and educational information. It specifically emphasizes the need to explain (a) the definition, (b) the calculation method, and (c) the result of the calculation at the end of the reporting period,
   2. the impact of a potential breach of these covenants on the classification of the liabilities,
   3. when the issuer is required to comply with them, and
   4. a description and the carrying amount of the related liabilities.
2. facts and circumstances, if any, indicating that the issuer may experience difficulties in complying with the covenants after the end of the reporting period, for example
   1. when it has taken action during or after the reporting period to prevent or mitigate a potential breach (including ongoing negotiations with lenders, amendments to loan arrangements concerning (temporary) covenant waivers, required remedial actions and remedy periods, and covenant revisions), and
   2. the fact that (i) it would not have complied with the covenants if compliance had been assessed at the end of the reporting period, or that (ii) it would have complied with the covenants if compliance had been assessed at the end of the reporting period, but expects that it may not comply with these covenants on the date specified in the loan arrangement (e.g. due to the cyclical nature of its activities).

Naturally, the above information needs to be disclosed only to the extent relevant to the assessment of the risk of breaches. The FSMA emphasizes that, in the context of that disclosure, issuers must apply the principles of materiality as described in IAS 1, par. 7: “ Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial statements make (…) ”. When making materiality judgements, issuers must consider both the likelihood of a covenant breach occurring and its (potential) impact on the liabilities (IFRS Practice Statement 2). Merely listing numerous covenants, of which only one entails an increased risk of breach, may be an example of obscuring material information.

References

The above-mentioned expectations are based on (a) IAS 1 “ Presentation of Financial Statements ”, par. 76ZA, (b) IFRS 7 “ Financial Instruments: Disclosures” , par. 32-34, (c) IFRS Practice statement 2 “ Making Materiality judgements ” and (d) Decision EECS/0211-09, included in the “ 11th Extract from the EECS’s Database of Enforcement ” published by ESMA.