Obtaining sufficient and appropriate evidence for debt covenants in assurance engagements can be complicated. Below are some considerations to help you along.
Covenant Basics
Debt covenants are limitations placed on borrowers to protect the interest of the lenders, as part of a loan agreement. By agreeing to abide by the covenant, the borrower can obtain loans with more favorable terms since the risk to the lender is lower1.
In third party loan agreements, there are no standard covenants that appear in all agreements, so every agreement must be carefully reviewed. Covenants can generally be split into two groups. BDC provides useful information on covenants in its glossary2 and some of this information has been recast below for direct reference.
- A keep-well clause describes what your company will, or will not, do while the loan is still outstanding. For example, it may require you to keep the same management team in place, or to agree not to sell any part of the company or incur additional debt, for the duration of the loan.
- Hard financial measures are financial ratios you are expected to meet throughout the lifetime of the loan. These stipulate that you maintain a minimum ratio that may relate to debt-to-equity, debt service coverage or current ratio.
The assessment of the covenant throughout the year is prescribed in the loan agreement, and can be annually, quarterly, monthly, or dependent on certain transactions occurring or not occurring.
- Positive covenants, also known as affirmative covenants, require a business to adhere to certain terms. They might require that the company maintains a certain type of insurance or delivers audited financial statements to the lending institution within a certain time after the year-end.
- Negative covenants are more straightforward. They simply restrict a company from engaging in certain actions by setting out things the borrower must not do.
Obtaining Evidence About Covenants
Depending on the type of engagement you are executing (audit, review, etc.), performing sufficient and appropriate procedures to cover the risk related to relevant assertions about classes of transactions, account balances, and related disclosures can vary.
The following are some considerations; however, procedures should be tailored to your client’s specific situation.
- Obtain the loan agreement and carefully review and/or summarize major terms.
- What are the covenants, and which specific balances are used to calculate them
- How frequently do they need to be calculated
- What happens if one or more of the covenants are not met (i.e. breached)
- Are the covenants measured based on a specific entity in the group only, a few entities combined, or the whole group
- Have the terms (including covenants) of the loan agreement been renegotiated since the prior period
- Obtain the client’s covenant calculations for each relevant period under review.
- Determine if the calculations are accurate and complete.
- In accordance with the relevant GAAP (i.e. IFRS, ASPE), determine if pursuant to the calculations:
- the loan balance is classified correctly and accurately valued
- the loan disclosures are accurate and complete
Common Pitfalls
Covenant Violations
When a covenant is violated, the loan may technically be in default; however, depending on the specific clauses (grace period) in the loan agreement and communications (demand repayment waiver) with the lender, the resulting presentation (current or long term) and disclosure can vary.
Some lender agreements contain cross-default provisions which could impact the classification of other third-party debt when a covenant violation exists. In addition, there should be consideration of management’s assessment of the entity’s ability to continue as a going concern because any material classification changes to debt (from non-current to current) may significantly impact the assessment.
Communications
Where there is uncertainty about anything in the loan agreement, ensure that the client communicates with the lender. We have noted that some practitioners have contacted the lender directly to find out the specific calculation for a covenant; however, this is discouraged as you are most likely in breach of the CPABC Code of Professional Conduct Rule 208 Confidentiality of information. It is strongly advised to have the client contact the lender instead with the specific questions on the covenant calculation and then have the client update their covenant calculations prior to your re-assessment of the calculations.
Footnotes
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