IASB Agenda ref 11

July 2017
STAFF PAPER
IASB Meeting
Project Materiality Practice Statement
Paper topic Sweep issuescovenants
CONTACT(S) Annamaria Frosi afrosi@ifrs.org +44 (0)20 7246 6907
Rachel Knubley rknubley@ifrs.org +44 (0)20 7246 6904

This paper has been prepared for discussion at a public meeting of the International Accounting Standards
Board (the Board) and does not represent the views of the Board or any individual member of the Board.
Comments on the application of IFRS Standards do not purport to set out acceptable or unacceptable
application of IFRS Standards. Technical decisions are made in public and reported in IASB Update.

Purpose and structure of this paper

1. The purpose of this paper is to ask the International Accounting Standards Board
(the Board) whether to confirm the proposed guidance on covenants in the draft
IFRS Practice Statement Making Materiality Judgements (the Practice Statement)
in the light of comments received.

2. The Paper is set out as follows:

(a) background information;

(b) issue 1information about covenants;

(c) issue 2impact of covenants on materiality of other information; and

(d) Appendix Aextracts from the latest staff draft of the Practice
Statement.

The International Accounting Standards Board is the independent standard-setting body of the IFRS Foundation, a not-for-profit corporation promoting the
adoption of International Financial Reporting Standards. For more information visit www.ifrs.org.

Page 1 of 15
 Agenda ref 11

Background information

3. In November 2016 1 the Board discussed some of the issues raised by respondents
to the Exposure Draft IFRS Practice Statement Application of Materiality to
Financial Statements (the Exposure Draft) and tentatively decided to:

(a) include in the final Practice Statement specific guidance on how to

assess the materiality of information about the existence and the terms
of a covenant, or a covenant breach; and

(b) emphasise that, in making the above assessment, an entity considers the
consequences of a covenant breach on the entitys financial position,
financial performance and cash flows; and the likelihood of such a
breach occurring.

4. The Board also tentatively decided that an entity is not required to re-perform its
materiality assessments the closer it gets to breaching a covenant. In other words,
the existence of a covenant should not influence the materiality assessment of
other information in the financial statementsother than information about the
covenants. In making this decision, the Board noted the impracticality, from an
operational point of view, of requiring an entity to continuously reassess its
materiality judgments the closer it gets to a covenant breach.

5. In December 2016 2 the Board examined the due process steps undertaken since
the publication of the Exposure Draft and instructed the staff to begin the balloting
process.

6. In March 2017, the staff issued for review a draft of the Practice Statement to a
number of external parties. The same draft was also made available to members
of the Board and the IFRS Interpretations Committee.

1
Agenda Paper 11B Covenants from November 2016.
2
Agenda Paper 11C Due process steps followed from December 2016.

Materiality Practice Statement Sweep issuescovenants

Page 2 of 15
 Agenda ref 11

7. The draft Practice Statement considers two issues that arise in making materiality
judgements when covenants, or similar contractual terms, apply:

(a) how an entity judges the materiality of information about the existence
and the term of a covenant or of a covenant breach (see issue 1,
paragraphs 816); and

(b) whether the entity considers the existence of a covenant when making
materiality judgements about other information included in the financial
statements (see issue 2, paragraphs 1743).

Issue 1information about covenants

8. The draft Practice Statement states that, in addition to the materiality factors
described in the materiality process, 3 materiality judgements on information about
covenants are specifically influenced by the consequences of a covenant breach
occurring and the likelihood of such a breach occurring (paragraph 83 of the draft
Practice Statement 4).

9. In particular, information about a covenant for which the consequences of a

breach would significantly affect the entitys financial position, financial
performance or cash flows, but for which there is a remote likelihood of the
breach occurring, is not material (paragraph 84 of the draft Practice Statement).

10. In other words, regardless of the significance of the consequences of a breach

occurring, information about the covenant is not materialdoes not need to be
included in the financial statementsif the likelihood of a breach occurring is
remote.

3
The materiality process has been discussed by the Board in October 2016, Agenda Paper 11C The
Materiality Process.
4
Relevant extracts from the latest staff draft of the Practice Statement are provided in Appendix A.

Materiality Practice Statement Sweep issuescovenants

Page 3 of 15
 Agenda ref 11

11. Some external reviewers, including some audit firms and standard-setters,
questioned whether the guidance in paragraph 84 of the draft Practice Statement
introduces a new disclosure threshold, as it suggests that information about the
covenants will always be material when the likelihood of a covenant breach
occurring is higher than remote.

12. One reviewer noted that the disclosure threshold in paragraph 84 of the draft
Practice Statement is equivalent to the disclosure threshold on contingent
liabilities in paragraph 28 of IAS 37 Provisions, Contingent Liabilities and
Contingent Assets:

A contingent liability is disclosed, as required by paragraph

86, unless the possibility of an outflow of resources
embodying economic benefits is remote [emphasis added].

13. However, the same reviewer also observed that a contingent liability and the
consequences on an entitys financial statements of a covenant breach occurring
are two different situations. The potential impact of a contingent liability is an
expense and an impact on equity, while the impact of a covenant breach depends
on the terms of the covenants and might have more significant consequences.

14. Paragraph 10 of IAS 37 defines a contingent liability as:

a possible obligation that arises from past events and

whose existence will be confirmed only by the occurrence
or non-occurrence of one or more uncertain future events
not wholly within the control of the entity [emphasis
added].

15. Contingent liabilities and consequences of a covenant breach occurring are similar
because both are affected by uncertain future events.

Materiality Practice Statement Sweep issuescovenants

Page 4 of 15
 Agenda ref 11

16. We therefore believe that paragraph 28 of IAS 37 provides the basis for
confirming the guidance on the disclosure of information about covenants in the
Practice Statement. However, in the light of:

(a) the comments received on the draft Practice Statement; and

(b) the fact that this disclosure threshold was not specifically discussed
during November 2016 Board meeting; 5

we would like you to confirm whether the guidance in the final Practice
Statement should state that information about a covenant is not material if the
likelihood of the breach occurring is remote.

Question 1information about covenant

Do you agree that the final Practice Statement should state that, on the basis of the
requirement in paragraph 28 of IAS 37, information about the covenant is not material if
the likelihood of the breach occurring is remote?

5
The disclosure threshold was nevertheless mentioned in paragraph 11 of the Agenda Paper 11B Covenants
from November 2016.

Materiality Practice Statement Sweep issuescovenants

Page 5 of 15
 Agenda ref 11

Issue 2impact of covenants on materiality of other information

17. The draft Practice Statement states that, since covenant terms are often defined on
the basis of information in IFRS financial statements, an entity makes materiality
judgements about this information without being influenced by the existence of
the covenant (paragraph 85 of the draft Practice Statement).

18. The entity makes materiality judgements in the preparation of its draft financial
statements without considering the existence of covenants and assesses its
compliance with any covenant once the draft financial statements have been
prepared (paragraph 86 of the draft Practice Statement).

19. The Board decided to provide the guidance described in paragraphs 1718 in
response to comments received on the Exposure Draft. The Exposure Draft
presented covenant compliance as an example of a situation where materiality
considerations would be more sensitive because they relate to areas of particular
importance to the primary users of an entitys financial statements (paragraph
28(a) of the Exposure Draft). Respondents 6 suggested the Board clarify whether
an entity needs to reassess its materiality judgements when it is close to non-
compliance with a loan covenant.

20. In making its tentative decision in November 2016, the Board observed that:

(a) when compliance with a covenant is assessed on the basis of

information in IFRS financial statements, that assessment must, by
definition, follow, rather than precede, the preparation of those
statements. To require that the assessment of such a covenant
influences the preparation of the information on which the covenant is
assessed would create a circular assessment and would be impractical
from an operational point of view.

(b) if lenders decide to define covenant terms on the basis of information in

IFRS financial statements, they need to accept that those financial
statements are prepared making materiality judgements.

6
EY, the Belgian Accounting Standards Board and the Italian Standard Setter, among others.

Materiality Practice Statement Sweep issuescovenants

Page 6 of 15
 Agenda ref 11

21. However, some external reviewers noted that the guidance provided in paragraphs
8586 of the draft Practice Statement seems to conflict with U.S. Securities and
Exchange Commission (SEC) guidance on assessing materiality. The SEC Staff
Accounting Bulletins, Topic 1: Financial Statements, M. Materiality, includes
among the considerations that may render material a quantitatively small
misstatement, the fact that the misstatement affects the entitys compliance with
loan covenants or other contractual requirements.

22. Similarly, some audit regulators require auditors to consider covenants when
establishing audit materiality. In particular, the International Standard on
Auditing (ISA) 450 Evaluation of misstatements identified during the audit states
that the effect on the compliance with debt covenants or other contractual
requirements may cause the auditors to evaluate a misstatement as material.

23. Some reviewers also commented that guidance conflicting with existing local
laws and regulations might be seen as a change, or a new interpretation, of
existing requirements in IFRS Standards, which would be contrary to the notion
that a Practice Statement is not supposed to change existing requirements or
introduce any new interpretations.

24. In the light of:

(a) the comments received; and

(b) the potential inconsistencies between the guidance in the draft Practice
Statement and guidance developed by other parties on the assessment of
materiality of errors;

we decided to ask the Board whether to confirm its decision.

Materiality Practice Statement Sweep issuescovenants

Page 7 of 15
 Agenda ref 11

25. In our view there are three possible alternatives the Board could choose from:

(a) Alternative Aretain the guidance in paragraphs 8586 and Example

Q of the draft Practice Statement (Impact of covenants on materiality
of other information section), reminding entities that local laws or
regulations might require an entity to consider compliance with debt
covenants or other contractual requirements when assessing the
materiality of an error;

(b) Alternative Bremove the guidance in paragraphs 8586 and

Example Q from the draft Practice Statement; or

(c) Alternative Creplace the guidance in paragraphs 8586 and Example

Q of the draft Practice Statement with alternative guidance (for
example, guidance stating that materiality judgements should be
influenced by the existence of covenants).

Alternative Aretain

26. The Board could choose to retain the current guidance in paragraphs 8586 and
Example Q of the draft Practice Statement and add a reference to the fact that
local laws and regulations might require a differentstricterassessment of
materiality (especially with regards to the assessment of the materiality of errors).

27. The draft Practice Statement already includes some guidance on the interaction
with local laws and regulations (paragraphs 2728 of the draft Practice
Statement). An entity that wishes to state compliance with IFRS Standards cannot
provide less information than the information required by those Standards, even if
local laws and regulations permit otherwise. However, providing information to
meet local legal or regulatory requirements is permitted by IFRS Standards, even
if that information is not material according to the materiality requirements in the
Standards.

28. The reasons for choosing Alternative A are the same as those that drove the
Boards tentative decision in November 2016 (see paragraph 20).

Materiality Practice Statement Sweep issuescovenants

Page 8 of 15
 Agenda ref 11

29. However, there are some concerns related to Alternative A:

(a) the current guidance on the impact of covenants on other materiality

assessment might create some confusion among preparers due to the
existence of conflicting guidance in the auditing standards and local
regulations. This would clash with one of the purposes of the Practice
Statementto provide a basis for discussion between an entity, its
auditor and regulator on the assessment of materiality, which could help
facilitate agreement.

(b) even if the Board tries to address the inconsistency issue adding a
reference to the fact that local laws and regulations might require a
stricter assessment of materiality, some might argue that guidance in
auditing standards and local regulations is not just stricter than the
guidance proposed in the draft Practice Statementit is developed on
completely different grounds (ie the impact on covenant compliance is
considered as a qualitative factor affecting materiality assessment).

(c) as mentioned in paragraph 23, guidance conflicting with existing local

laws and regulations might be seen as a change, or a new interpretation,
of existing requirements in IFRS Standards. A Practice Statement
should not change any existing requirements in IFRS Standards, nor
introduce any new requirements.

Alternative Bremove

30. The Board could remove paragraphs 8586 and Example Q from the draft
Practice Statement.

31. Alternative B avoids creating any actual or perceived change in the way an entity
assesses materiality when covenants or other contractual requirements apply.
However, if the Board chooses Alternative B, the Practice Statement would fail to
provide preparers with useful guidance in an area that it is difficult to make
materiality judgements.

Materiality Practice Statement Sweep issuescovenants

Page 9 of 15
 Agenda ref 11

32. If the Board supports Alternative B, it could retain in the final Practice Statement
guidance on how to assess the materiality of information related to covenants
(paragraphs 8284 and Example P of the draft Practice Statement). That guidance
is uncontroversial and, we believe, could result in relevant disclosures about the
existence of covenants and the consequences of their breach.

Alternative Creplace

33. The Board could decide to replace the proposed guidance in the draft practice
statement with guidance that is more aligned with the content of the Exposure
Draft. To do this the Board would need to agree that the existence of covenants,
or other similar contractual requirements, can influence materiality judgements (ie
the existence of covenants is a qualitative factor affecting materiality assessment).

34. Alternative C eliminates potential conflicts with current auditing guidance and
local regulations. However, the Board risks suggesting something that is
impractical from an operational point of view (ie requiring a continuous
reassessment of materiality judgements the closer the entity gets to a covenant
breach).

35. Moreover, as observed by the Board during its discussion in November 2016, if
lenders decide to define covenant terms on the basis of information in IFRS
financial statements, they need to accept that those financial statements are
prepared making materiality judgements.

36. Finally, stating that materiality judgements are influenced by the existence of
covenants might imply that those judgements are also influenced by other
contracts whose terms are based on information from IFRS financial statements
(eg profit sharing agreements, management incentive plans, etc.).

Materiality Practice Statement Sweep issuescovenants

Page 10 of 15
 Agenda ref 11

Staff recommendation

37. Each of the alternatives we described in paragraphs 2636 has pros and cons. In
formulating our recommendation, we primarily considered the objectives the
Board expected to achieve with the publication of the Practice Statement.

38. In particular, the Board expects the Practice Statement will:

(a) enhance awareness of the role of materiality in helping to promote

positive changes in behaviour (such as to discourage rigid adherence to
checklists by an entity when preparing financial statements);

(b) encourage an entity to exercise judgement to a greater extent in

preparing financial statements, leading to a reduction in boilerplate
disclosures and redundant information and providing a framework to
assess the need for information in the financial statements that is
additional to disclosure requirements specified by IFRS Standards; and

(c) provide a useful reference point for discussions between an entity, its
auditors and regulators on the assessment of materiality, which could
help facilitate agreement.

39. Moreover, when discussing the audience of the Practice Statement, 7 the Board
noted that the Practice Statement is also likely to help other parties involved in
financial reporting (such as, for example, auditors and regulators) understand the
approach an entity follow in making materiality judgements when preparing its
financial statements.

40. We believe that the Board might fail to meet these objectives if it retains the
current guidance on the impact of covenants on other materiality assessment in the
final Practice Statement. That guidance might create confusion among parties
involved in financial reporting due to the existence of conflicting guidance in
auditing standards and local regulations. This confusion could risk undermining
the entire Practice Statement reducing the effectiveness of the document.

7
Agenda Paper 11B Audience, focus and definition from October 2016.

Materiality Practice Statement Sweep issuescovenants

Page 11 of 15
 Agenda ref 11

41. We also believe that replacing the proposed guidance in the draft practice
statement with guidance that is more aligned with the content of the Exposure
Draft is not advisable either. The Board risks suggesting an endless reassessment
of the materiality judgements that might lead to a situation where all figures in the
financial statements might become material.

42. We therefore recommend the Board chooses Alternative Bremove paragraphs

8586 and Example Q from the draft Practice Statement.

43. We recommend retaining the guidance on how to assess the materiality of

information related to covenants (paragraphs 8284 and Example P of the draft
Practice Statement). This guidance is uncontroversial and, we believe, could
result in relevant disclosures about the existence of covenants and the
consequences of their breach.

Question 2impact of covenants on materiality of other information

Do you agree that the Board:

(a) removes the guidance about the impact of covenants on materiality judgements about
other information (paragraphs 8586 and Example Q of the draft Practice Statement)
from the final Practice Statement? and

(b) retains the guidance about how to assess the materiality of information related to
covenants (paragraphs 8284 and Example P of the draft Practice Statement) in the final
Practice Statement?

Materiality Practice Statement Sweep issuescovenants

Page 12 of 15
 Agenda ref 11

Appendix Aextracts from the latest staff draft of the Practice Statement

A1. Proposed guidance on covenants and on the interaction with local laws and
regulations from the latest staff draft of the Practice Statement is reproduced
below.

Covenants
81 Two considerations arise in making materiality judgements when loan agreement terms
(covenants), or similar contractual terms, apply:
(a) how an entity judges the materiality of information about the existence and terms of a
covenant, or of a covenant breach; and
(b) whether the entity considers the existence of a covenant when making materiality
judgements about other information included in the financial statements.

Information about covenants

82 An entity assesses the materiality of information about the existence and terms of a covenant, or of
a covenant breach, to decide whether to provide that information in the financial statements. This
assessment is made in the same way as for other information, ie by considering whether that
information could reasonably be expected to influence decisions that its primary users make on the
basis of the entitys financial statements (see A four-step materiality process, from paragraph 33).
83 In particular, when a covenant exists, the entity considers both:
(a) the consequences of a breach occurring, ie the impact a covenant breach would have on
the entitys financial position, financial performance and cash flows. If those
consequences would significantly impact the entitys financial position, financial
performance or cash flows, then the information about the existence of the covenant and
its terms is likely to be material. Conversely, if the consequences of a covenant breach
would not significantly impact the entitys financial position, financial performance or
cash flows, then disclosures about the covenant might not be needed.
(b) the likelihood of the covenant breach occurring. The more likely it is that the covenant
breach would occur, the more likely it is that information about the existence and terms
of the covenant would be material.
84 In assessing whether information about a covenant is material, a combination of the above
considerations applies. Information about a covenant for which the consequences of a breach would
significantly affect the entitys financial position, financial performance or cash flows, but for
which there is a remote likelihood of the breach occurring, is not material.

Example Passessing whether information about covenants is material information

Background
An entity has rapidly grown over the past five years and recently suffered some liquidity problems. A
long-term loan was granted to the entity in the current reporting period. The long-term loan arrangement
includes a provision that requires the entity to maintain a ratio of debt to equity below a specified
threshold, to be measured at each reporting date (the covenant). According to the long-term loan
arrangement, the debt to equity ratio has to be calculated on the basis of debt and equity figures as
presented in the entitys IFRS financial statements. If the entity breaches the covenant, the entire long-
term loan becomes payable on demand. The disclosure of covenant terms in an entitys financial
statement is not required by any local laws or regulations.

Materiality Practice Statement Sweep issuescovenants

Page 13 of 15
 Agenda ref 11

Application
Paragraph 31 of IFRS 7 Financial Instruments: Disclosures requires an entity to disclose information
that enables users of its financial statements to evaluate the nature and extent of risk arising from
financial instruments to which the entity is exposed at the end of the reporting period.
In the preparation of its financial statements, the entity assesses whether information about the existence
of the covenant and its terms is material information, considering both the consequences and the
likelihood of a breach occurring.
In these circumstances, the entity assessed the consequences of the breach occurring as being significant:
considering its recent liquidity problem, any acceleration of the long-term loan repayment plan could
significantly impact the entitys financial position and cash flows.
The entity also considered the likelihood of a breach occurring.
Scenario 1the lender defined the covenant threshold on the basis of the three-year business
plan prepared by the entity, adding a 10 per cent tolerance on top of the forecast figures
In this scenario, even though the entity has historically met its past business plans, it assessed the
likelihood of a breach occurring as higher than remote. Therefore, information about the existence of
the covenant and its terms was assessed as material and disclosed in the entitys financial statements.
Scenario 2the lender defined the covenant threshold on the basis of the three-year business
plan prepared by the entity, adding a 200 per cent tolerance on top of the forecast figures
In this scenario, the entity assessed the likelihood of a breach occurring as remote, on the basis of its
historical track record of meeting its past business plans and the magnitude of the tolerance included in
the covenant threshold. Therefore, although the consequences of the covenant breach were assessed as
significant, the entity concluded that information about the existence of the covenant and its terms was
not material.

Impact of covenants on materiality of other information

85 Covenant terms are often defined on the basis of other information in IFRS financial statements, eg
the amount of equity or debt (sometimes called inputs of the covenant calculation). An entity
makes materiality judgements about this other information without being influenced by the
existence of the covenant.
86 The entity makes materiality judgements in the preparation of its draft financial statements without
considering the existence of covenants and assesses its compliance with any covenant, or similar
contractual terms, once the draft financial statements have been prepared. The draft financial
statements are then adjusted accordingly in the case of a covenant breach (eg by changing the
classification of the liability arising from a long-term loan from non-current to current).

Example Qmaking materiality judgements on the input of a covenant calculation

Background
Assume the same facts as in Example P, Scenario 1, except that the long-term loan arrangement requires
the entity to maintain the amount of property, plant and equipment (PP&E) additions for each reporting
period below a specified threshold, to be measured at each reporting date (the covenant). According to
the long-term loan arrangement, the amount has to be calculated on the basis of PP&E figures as included
in the entitys IFRS financial statements.
The entity has historically applied a policy of capitalising capital expenditures only in excess of a
specified threshold and recognising any smaller amounts as an expense.

Materiality Practice Statement Sweep issuescovenants

Page 14 of 15
 Agenda ref 11

Application
In the preparation of its financial statements, the entity applied the considerations outlined in the
materiality process to assess whether this accounting policy would have a material effect on its financial
statements. It exercised its judgement and concluded that the accounting policy will not have a material
effect on the current financial statements.
While verifying its compliance with the covenant terms, the entity realised that a lower capitalisation
threshold would have caused it to breach the covenant. However, since compliance with the covenant
terms is assessed on the basis of IFRS financial statements, whose preparation inherently involves the
assessment of materiality, the potential breach of the covenant should not influence the entitys
materiality judgements on the accounting policy.
The entity confirmed the materiality assessment of its capitalisation policy and concluded the covenant
was not breached.

Interaction with local laws and regulations

27 An entitys financial statements must comply with the requirements in IFRS Standards, including
requirements related to materiality (the materiality requirements), for the entity to state its compliance
with those Standards. Hence, an entity that wishes to state compliance with IFRS Standards cannot
provide less information than the information required by those Standards, even if local laws and
regulations permit otherwise.
28 Nevertheless, local laws and regulations may specify requirements that affect what information is
provided in the financial statements. In such circumstances, providing information to meet local legal
or regulatory requirements is permitted by IFRS Standards, even if that information is not material
according to the materiality requirements in the Standards. However, such information must not obscure
information that is material according to IFRS Standards. 8

8
See paragraph 30A of IAS 1 and paragraph BC30F of the Basis for Conclusions on IAS 1.

Materiality Practice Statement Sweep issuescovenants

Page 15 of 15