Breach of bank covenants

How should borrowings be presented in the balance sheet if covenants have been breached?

It is common for financial covenants to be imposed on borrowings. Such covenants usually need to be reported on at regular intervals, for example quarterly or yearly. Whether a covenant is breached at the balance sheet date is often only determined after the balance sheet date, once the financial position and its performance at the reporting date have been determined. If the covenant was breached at the balance sheet date, triggering repayment of the liability, the borrowing will need to be classified as current on the balance sheet.

In practice, however, entities often reach an agreement with their lender(s) that grants them the right to defer repayment for at least 12 months from the reporting date. Such agreements are commonly referred to as waivers. If a waiver is obtained after the balance sheet date but prior to the approval of the financial statements, the question arises as to whether the borrowing should be classified as current or non-current on the balance sheet at the reporting date.

Framework 5 stipulates that the objective of financial statements is to give information about the financial position, the cash flows and the results of operations of entities in a structured way in order to support the user’s decision-making process. Considering this fundamental objective, we believe it is acceptable to present such borrowings as non-current, even if the waiver was only obtained after the balance sheet date. In our view, presenting such liabilities as non-current provides the reader with better information regarding the timing of future cash flows and liquidity risks associated with the borrowing.

It is, however, also acceptable to treat the receipt of the waiver as a non-adjusting event on the basis that it is new information about conditions that did not exist at the balance sheet date.

Regardless of which approach is taken, we would expect the reporting entity to describe the breach of covenant and the subsequent receipt of the waiver in the notes to the financial statements.

Cash flow statements: restricted cash

Should restricted cash be classified as cash and cash equivalents in the cash flow statement?
Swiss GAAP FER 4 is silent on restrictions in use or ownership restraints. We believe that management should consider whether the restricted cash meets the criteria of cash and cash equivalents or whether the funds are constrained in such a way that the definition is not met. Judgement is required to assess the economic substance of the restrictions. In practice the following restrictions can occur:

• covenants require an entity to maintain certain minimum cash balances;
• cash is available for use by a subsidiary, but restrictions apply for the wider group;
• a subsidiary operates in a country where the government restricts the transfer of cash abroad, such that the cash is not freely transferable around the group; or
• the cash is deposited in a group treasury function.

In our view, the definition of cash and cash equivalents can often be met in these situations. As such, the classification as a cash fund is appropriate. Entities should consider disclosing information about the restrictions, such as the amounts and characteristics.
By contrast, restrictions can be so severe that the definition of cash and cash equivalents is not met. This is the case, for example, if two signatures are required to access a bank account, one of which is from an independent third party ‒ such as in situations where a customer makes an advance payment for goods and services that will not be delivered until sometime in the future, to a secure account, with the desire that the funds be kept separate until delivery. The entity should clearly distinguish these restricted funds from cash and cash equivalents and present them in accordance with Swiss GAAP FER 3 Presentation and format. Relevant information on restrictions and possible implications should be disclosed.

Interim financial reporting ‒ Inventories: Under what circumstances can simplifications be applied when determining balances and accounting for transactions of the period?

As interim financial statements must be prepared on the basis of the same principles as the annual financial statements [FER 31/11], FER 17 Inventories is applicable for the presentation of inventories. They should be measured the same way as at the end of the financial year, that is at the lower of cost and net realisable value. [FER 17/3]
Based on FER 31/11, simplifications can be applied in the determination of inventories for purposes of interim financial statements if such simplifications do not adversely affect the presentation of the course of the business. In our view, simplifications are appropriate if management can demonstrate that the financial information prepared with simplified methods does not differ materially from the financial information that would have been reported otherwise.

Regarding inventory, for example, the following simplifications can be observed in practice:

• Refraining from full inventory counts at an interim date, but relying instead on continuous inventory records, or
• Applying simplified gross profit ratios when determining the cost of inventory.

Management needs to apply judgement when determining what simplifications are appropriate in the given circumstances. The simplifications above might be appropriate when preparing interim financial information if management expects only small inventory differences or small variances in margins.

No matter what simplifications have been applied, management should in our view explain them in the notes to the interim financial statements.

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