Impact of AASB 16 on facility agreements

AASB 16 Leases, being the Australian equivalent of IFRS 16 Leases, is effective for periods beginning on or after 1 January 2019. The new standard requires a lessee to recognise most types of operating leases on its balance sheet.  Finance leases have long been recognised on a lessee’s balance sheet as if the lessee owns the leased asset. The effect of AASB 16 is to remove the distinction between finance leases and operating leases and to treat all leases the same for accounting purposes. The result is that lessees must recognise a ‘right-of-use’ asset and a corresponding lease liability for almost every lease it has entered into.

This article focusses on the impact of AASB 16 on facility agreements.

Effects of AASB 16

The effects of recognising operating leases on the lessee’s balance sheet are as follows:

• the principal amount of the present value of future lease payments payable under an operating lease is now treated as a borrowing liability or a notional amortising loan. This causes an increase in the “Financial Indebtedness”, “Borrowings” or “Total Debt” figures (assuming operating leases are not carved out – see below);
• part of the interest payments under an operating lease is recharacterised from operating expense to interest expense. This causes an increase in the “Finance Charges” or “Interest Expense” figures;
• the right to use the leased asset is reflected in the balance sheet similarly to a purchased asset, increasing the “Total Assets” or “Total Tangible Assets” figures; and
• part of the lease payments is recharacterised from operating expense to depreciation, which increases depreciation.

Essentially, the lessee appears to be both richer in assets and deeper in debt.

As regards earnings before interest, tax, depreciation and amortization (EBITDA), lease payments due under an operating lease are no longer deducted as an operating expense. The net effect of this and the above factors is that the earnings, interest and depreciation elements of EBITDA increase, with EBITDA increasing overall.

Financial covenants

AASB 16 has significant impacts on the calculation of key financial covenants, as described below:

• Debt service cover ratio. This is the ratio of cashflow (being adjusted EBITDA) to debt service (being principal repayments, interest payments and other mandatory debt payments). Both cashflow and debt service increase, broadly by the same amount.
• Fixed charge cover ratio. This is the ratio of ‘EBITDA plus rental’ to ‘interest expense plus rental’. EBITDA and interest expense both increase and rental reduces.
• Interest cover ratio. This is the ratio of EBITDA to interest expense for a period. Both EBITDA and interest expense increase.
• Leverage ratio. This is the ratio of the group’s total net indebtedness to earnings (usually EBITDA) for a period. Both indebtedness and earnings increase.
• Minimum net assets. The borrower’s assets increase as the right to use the leased asset is reflected on the balance sheet.

Any covenant cures that may be available should be checked.

Undertakings

The following undertakings may also be affected:

• Incurrence of Financial Indebtedness. A facility agreement typically includes restrictions on the incurrence of Financial Indebtedness. However, the borrower will be allowed to incur Permitted Financial Indebtedness, which will usually include an allowance for Financial Indebtedness arising under leases up to a specified threshold. If operating leases are included in “Financial Indebtedness”, this threshold will be reached or exceeded more quickly, possibly without new leases being entered into.  Permitted Financial Indebtedness is also often restricted by reference to a factor of EBITDA or another financial ratio. Again, these are likely to be impacted by the effects of AASB 16 referred to above.
• Guarantor coverage. The guarantor coverage test is an undertaking that entities in the group whose EBITDA and / or assets represent a specified minimum percentage of the group’s consolidated EBITDA or gross assets must accede to the facility agreement as guarantors. This ensures that adequate upstream guarantee support is in place. Given that both assets and EBITDA increase as a result of AASB 16, this test will be more easily met by the borrower and may need be revisited. Note that, as a guarantor coverage test is not a financial covenant, the ‘frozen GAAP’ protections (see below) will not be available.
• Any other permissions, restrictions or prohibitions that are based upon or affected by financial ratios or thresholds will potentially be affected. These might include:
  • excess cashflow sweeps;
  • restrictions on the payment of dividends or making of distributions; and
  • restrictions on new acquisitions.

Events of default

It is common for some events of default to incorporate de minimus thresholds. For example, the cross-default event of default is typically triggered where Financial Indebtedness above a specified amount owing to a third party is not paid when due. If operating leases are included in the definition of “Financial Indebtedness”, this event of default will be more readily triggered.  Any such thresholds in the events of default should be checked to see if they are adequate.

Other provisions in the facility agreement

The impact of AASB 16 should also be considered if:

• the facility limit is a factor of EBITDA or similar measure;
• there is a margin ratchet or pricing grid, whereby the interest payable is determined by reference to certain financial ratios, such as the leverage ratio, having been met;
• there are solvency-related representations and warranties.

Current Australian market

Many Australian facility agreements have, however, effectively preserved the pre-AASB 16 position by way of two key provisions:

• The LMA and APLMA amended their recommended forms of facility agreements in anticipation of IFRS 16 coming into effect. The definition of “Financial Indebtedness” was amended to optionally exclude any liability in respect of a lease which would, prior to 1 January 2019, have been treated as an operating lease. This optional wording has been very widely adopted, with the effect that in most facility agreements the concept of Financial Indebtedness excludes operating lease liabilities and the concept of Finance Charges excludes the interest element of operating lease liabilities.
• The LMA and APLMA recommended forms of facility agreements include an optional ‘frozen GAAP’ clause. This essentially provides that each set of financial statements must be prepared on the same basis as the original financial statements provided at the outset of the facility, unless there has been a change in GAAP.  If so, the financial statements are required to reflect the changes in GAAP, but, additionally, the auditors must provide a description of the changes necessary for the statements to reflect the principles and practices on which the original financial statements were prepared and sufficient information to enable the lender to determine whether the financial covenants have been met. This necessitates the production of two sets of accounts (one for measuring financial covenants and the other for compliance with accounting standards) or, alternatively, a reconciliation statement. The frozen GAAP clause has been very widely accepted for the certainty it provides.

However, there are significant downsides to relying on these provisions in the longer term, not least the administrative burden and cost of producing two sets of accounts or detailed reconciliation statements. The frozen GAAP clause was never really intended to be a long term solution and many facility agreements also include provisions requiring lenders and borrowers to take steps towards agreeing on amendments to financial covenants where there is a change in GAAP. It is, in any case, inevitable that the impact of AASB 16 will need to be fully addressed in facility agreements at some point. It is now strongly advisable to expedite the detailed work of analysing the impacts on financial ratios and other provisions. For example, debt and EBITDA will both increase, which is likely to result in an increase in the leverage ratio. Further, as margin grids generally specify the margin payable at any given time according to the leverage ratio, these grids will need to be reviewed and probably reset. A bespoke approach needs to be taken in each case as companies have been taking differing approaches to the transition to AASB 16, also making the comparisons between businesses difficult.

It should be evident that a thorough review of a facility agreement is required to understand the impact of AASB 16 across a variety of provisions. Parties should check the above possible impacts and consider whether financial ratios or thresholds should be reset to avoid breaches and other unanticipated results.