An earlier newsletter (no. 146) already discussed the importance of financial covenants for designating financial liabilities as either current or non-current. In this article, we will take a closer look at the required disclosures in the notes to the financial statements in future annual reports.
Financial covenants are contractual agreements between lenders and borrowers that specify certain financial ratios that the company must meet in order to fulfill the terms of the loan. These ratios often pertain to aspects such as debt, liquidity or profitability.
Such covenants not only serve to protect lenders, but also promote responsible corporate governance. By specifying certain key performance indicators, covenants allow risks to be identified at an early stage and help to keep the company on track. Non-compliance can result in higher interest rates or, in the worst case, the obligation to repay the loan immediately.
The disclosures in the notes to the financial statements regarding financial covenants previously stemmed primarily from the requirements to present the liquidity risk appropriately. The reason for this is that IFRS 7.B10A(a) requires disclosures in the notes if the cash flows presented in the liquidity analysis could become due significantly earlier than presented. It was already necessary to explain covenants in particular that could lead to early repayment of a loan and whose non-compliance is not unlikely.
There are now further disclosure requirements for companies. IAS 1.76ZA contains new disclosures for financial years beginning on or after 1 January 2024.
The following information must be provided in future:
- Disclosures on covenants (type, agreed date of fulfillment),
- Carrying amount of the associated liabilities
- Facts and circumstances indicating difficulties in meeting the covenants (e.g. measures taken to prevent a future breach)
Could there still be constellations in which companies can dispense with the disclosure of financial covenants? It is helpful to take a look at IFRS Practice Statement 2, “Making Materiality Judgements”. It states that the notes to the financial statements need to include disclosures that are relevant to the readers of the financial statements. According to paragraphs 81-83, entities must assess the relevance of disclosures on financial covenants in light of the following aspects:
- What would the consequences of a breach of the covenants be for the company's net assets, financial position, results of operations or cash flow?
- What is the probability of such a scenario?
As a result, the only time it is permissible not to describe covenants in the notes is if the impact is either minor or the probability of an impact can be classified as “remote”.
Given that the end of the financial year is approaching, all financing agreements should already be reviewed now to determine whether they need to be explained with regard to covenants.
Source: KPMG Corporate Treasury News, Edition 148, October 2024
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Andrea Monthofer, Senior Managerin, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG