Mercia carries out hot and cold audit file reviews for a significant number of firms and there are often recurring themes which are observed as part of those reviews. One such issue concerns loan covenants.
From an audit perspective these can potentially have a significant effect if the audited entity has not complied with the conditions imposed.
Loan covenants can take a variety of forms such as ratios of debt to equity, other asset-based ratios or simply providing financial information to the lender within a set period. However, they are often earnings-related with a link to a measure such as earnings before interest, tax, depreciation and amortisation (EBITDA). I have seen instances where this measure has also been used in combination with a restriction applied to the amount of directors’ loan accounts leading to a slightly more complicated calculation than the basic earnings-related figure.
Significance of loan covenants in light of FRS 102
Section 11.47 of FRS 102 provides that where there has been a payment default or breach of the terms applicable to loans at the reporting date, which has not been remedied by the reporting date, then the audited entity has to make certain disclosures in its financial statements. These include details of the breach along with the carrying value of any affected loans and whether or not those breaches were remedied (or the terms of the loans renegotiated) prior to the financial statements being approved. This does not apply to entities preparing accounts under section 1A.
Non-compliance with the terms of loan covenants has a number of potential implications from an audit perspective:
- Do the financial statements contain sufficient disclosure in line with the requirements of FRS 102?
- Is there a need to reclassify loans disclosed as due after more than one year in light of covenant breaches?
- Does the extent of the default or non-compliance call into question the going concern assumption?
Any instances of non-compliance need to be identified for follow up action with evidence on file of any action taken by the financial institution. In some cases I have seen, banks can have a relatively relaxed attitude to covenant breaches and do not seek to take action but this is by no means universal.
The subject of loan covenants is one which needs to be flagged up to audit staff as part of the audit planning process so that they are aware of the potentially significant implications of any breaches. Copies of those loan agreements should be obtained and the specific covenants should be listed and checked for compliance with a clear working paper and conclusion on the audit file demonstrating the extent of the auditor’s work in this area.
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