As the economy grows many businesses are looking at ways in which they can grow with the economy. Cash is going to be required to fund this growth and many businesses will need to raise new sources of funding. New debt funding is often a good source of those funds but the impending application of FRS 102 will mean company finance directors will have to be even more vigilant when negotiating the terms that funding.
Any lender wants to minimise the risk of economic loss and so covenants are created to measure the capability of a business to make loan repayments.
Covenants are often based on measures of profit or assets derived from audited financial statements. Future changes in accounting standards can cause changes to profit or asset measures which in turn cause covenants to be failed. This is despite there being no change to the entity's cash flows.
There are ways you can guard against future potential covenant failures, the most basic of which is for you to agree frozen GAAP covenant tests, whereby tests will be performed on the basis of existing GAAP. Whilst this has the advantage of ensuring future expected or unexpected changes to accounting standards will not impact on the measurement of covenants, this can result in your finance team needing to keep two sets of books and records or performing GAAP reconciliations to satisfy the lender.
An alternative is for you to agree covenants that are not based on profit or asset measures, for example cash based covenants; flows of actual cash will not change. Although, if these covenants are based on measures in the cash flow statement you should make yourself aware of the changes to the composition of the cash and cash equivalent balances which will be reported in the cash flow statement, and the changes to the presentation of the cash flow statement.
Or, you could invest the time to understand the impact that these new accounting standards will have on your financial statements and ensure that any covenants being agreed now will not be adversely affected by the move to FRS 102.
When entering into a new funding arrangement, you will also want to make sure that you are appropriately managing your business's financial risk. Whatever risk management strategy you choose I have a few gentle words of advice.
The range of products available is large and whilst some might be described similarly the precise terms of these products often vary significantly. To manage cash flow risk, for example, the types of instruments I see most often are interest rate swaps, caps, floors and collars. However, a simple vanilla interest rate swap can soon become more complicated, for example some entities have entered into callable interest rate swaps where, after a short lock in period, the bank can cancel the arrangement at its option.
Why does any of this matter you might ask? Answering this means understanding how FRS 102 treats these instruments. The basic treatment of these derivative instruments is that they are carried on the balance sheet at fair value with movements in this value recognised in profit or loss. These products tend to be volatile; movements in value are far more sensitive to changes in interest rates than the loan whose risk you might be seeking to manage. Hence recognising movements in this fair value through profit or loss tends to make your profit more volatile.
In itself this is not necessarily a problem, provided users of your financial statements understand that this additional volatility is actually a result of your good intentions to manage the cash flow volatility of your business. Many listed companies have found ways to explain their results which ignore this volatility, for example using adjusted profit measures which add back the gains and losses on these instruments to enable reporting of "underlying earnings".
However, explaining your results is just one of the issues that you might face; this volatility might have other impacts on your business. For example, it may impact on the measurement of your covenants as I have previously explained. If you have other arrangements linked to profitability, for example bonus or contingent acquisition arrangements, it might also have other cash flow effects.
Understanding the impact that entering into these products might have on these other arrangements is just part of the due diligence you should be performing.
There is an accounting way to manage this volatility too; the use of hedge accounting. Hedge accounting is not mandatory but it allows the gains and losses on these products to be reported in other comprehensive income rather than profit or loss. However, there are stringent rules attached to whether hedge accounting can be used. For example, the callable swaps I mentioned previously would not qualify for hedge accounting. Adopting hedge accounting also requires the preparation of hedge documentation and an ongoing assessment of the effectiveness of the product in creating cash flows which manage the original cash flow risk.
Hedge accounting might also have other beneficial effects…
As I mentioned above these products can be very volatile, where they are out of the money a large liability may be recognised in the balance sheet with the loss either recognised in profit or loss or other comprehensive income depending on whether you have applied hedge accounting, and applied it correctly!
If this loss is recognised in profit or loss then that loss immediately reduces the profits that the company can distribute. However, where a company has adopted hedge accounting the loss taken to other comprehensive income is recognised in a separate hedge reserve and will not immediately reduce the profits available for distribution.
FRS 102 will obviously have other effects on the reported profit and also on realised profits but the volatility of these financial products can turn a steady-dividend-paying company into one where the potential for dividends fluctuates on an annual basis.
A responsible finance director will want to perform due diligence when refinancing a business including selecting the right type of finance and the right products to manage any resulting financial risk. In my view, this due diligence should include the following questions:
• how will I manage the impending change to FRS 102 on any proposed covenants
• what risk do I think the business can bear
• what options are there for managing that risk
• what potential impact could the product have on reported and realised profits
• what other arrangements exist which might be affected by increased volatility
• would the product be eligible for hedge accounting
• what advice should I take on the options available to me?
This is not an exhaustive list of questions and there are many more that a diligent finance director will want to consider. So, if you are refinancing, I think giving proper thought to FRS 102 is the healthy option for you and your business.
Jake Green is director of Financial Reporting at Grant Thornton UK LLP