INTM578100 - Thin capitalisation: interest cover

The effect of accounting standards

Accounting standards may have an effect on the profit & loss account that will need to be considered when discussing the interest cover of a borrower. It is not possible here to write down all the possible permutations, but merely to give some guidelines. In all cases, the main principles are:

• always start with the audited profit & loss account of the UK Borrowing unit or the UK borrower and its 51% subsidiaries for advances or interest payments made after 1 April 2004. In cases where there is dispute about the position, the consolidated position is required, representing the results of that unit.
• generally, if the effect of an accounting standard on the profit & loss account is of a non-cash type, the less likely it is to be taken into account by a third-party lender.
• consult the HM Revenue & Customs accountant when in doubt.
• If there is a change in the accounting standard applied, for example a change from UK GAAP to International Accounting Standards then, when monitoring compliance with covenants, computational adjustments should be made to re-instate the accounting position upon which covenants were based.

An example to demonstrate the ideas is given below:

Financial Reporting Standard 15 (‘FRS15’) – Tangible Fixed Assets

FRS15 is valid for accounting periods ending on or after 23 March 2000, and sets out the principles for accounting for tangible fixed assets, except for investment properties (dealt with in Standard Statement of Accounting Practice 19 (SSAP19). Its objective is to ensure that tangible fixed assets are accounted for on a consistent basis.

The FRS permits a company to choose whether its tangible fixed assets are stated at cost or revalued amount. Where revaluation is used, all assets with similar nature, function or use must be revalued, and the valuations must be kept up to date. It acknowledges that in a limited number of cases no depreciation charges may be made on the grounds that it is immaterial. If this is the case, or if depreciation is calculated on a basis that assumes that the useful economic life of an asset is greater than fifty years, the standard requires that annual impairment reviews be performed, to ensure that the ‘carrying amount’ of the asset is not overstated.

The effect of all this is that an impairment value may be debited to the profit & loss account in a particular year, thus apparently reducing the interest cover for that year. If the debit is significant, it is likely to be shown as an exceptional item. The question is: what account should be taken of this when calculating the interest cover?

Unless there is something peculiar about a particular case, the debit is a non-cash item. It will not normally affect the ability of the company to service its debt. It can therefore be ignored for the purpose of calculating interest cover where the aim is to look at the cash-flow ability to service debt.

See also INTM585000 onwards for the effect of FRS17 accounting on thin capitalisation cases.