## **Learning Outcomes**

After reading this article, you will be able to analyse how choices in accounting policies and estimates affect financial ratios and loan covenants. You will identify ways in which accounting decisions may alter key performance indicators, understand the potential risks of covenant breaches for entities, and communicate findings appropriately in ACCA exam scenarios.

## **ACCA Strategic Business Reporting (SBR) Syllabus**

For ACCA Strategic Business Reporting (SBR), you are required to understand the consequences of accounting policy decisions on financial statement analysis and stakeholder communication. This article addresses the following syllabus points:

- Evaluate the impact of accounting policies and accounting estimates on reported financial information
- Interpret financial statements for different stakeholders, including the assessment of performance using ratios
- Assess the implications of accounting choices for loan covenants and other contractual arrangements
- Communicate the effects of accounting policy selection and estimation uncertainty with professional clarity

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. ABC Ltd has two options for measuring investment properties: cost model and fair value model. How might the choice impact its return on capital employed (ROCE) and gearing ratios?
2. A company switches from straight-line to reducing balance depreciation. How will this affect its interest cover and asset turnover ratios in the early years?
3. LMN plc has a loan covenant requiring a minimum current ratio of 1.5. Which accounting decisions could influence whether this target is met?
4. Define a loan covenant and explain the risks for an entity breaching a covenant as a result of an accounting policy change.

## **Introduction**

Accounting policy decisions can significantly influence reported profit, totals on the statement of financial position, and, consequently, key ratios used by stakeholders. Banks and other lenders may include ratio-based covenants in loan agreements, requiring entities to maintain specific metrics. Policy choices, estimation techniques, and fair value elections can be used, legitimately or otherwise, to meet targets or avoid breaches. Professional accountants must both understand these impacts and communicate them clearly.

## The Link Between Accounting Choices and Ratios

Entities preparing financial statements under IFRS are often permitted to select from alternative accounting policies or estimation techniques in areas such as revenue recognition, property valuation, depreciation method, and inventory costing. These choices impact the calculable amounts of profit, assets, liabilities, and equity within a single or across multiple reporting periods.

Key ratios affected include:

- Profitability ratios (e.g., ROCE, operating margin)
- Liquidity ratios (e.g., current ratio, quick ratio)
- Solvency/gearing ratios (e.g., debt/equity, debt/total assets)
- Efficiency ratios (e.g., asset turnover)

> **Key Term: Accounting policy**  
> A specific principle, rule, or measurement basis selected and applied by management in preparing and presenting financial statements.
>
> **Key Term: Accounting estimate**  
> A judgement or assumption made in quantifying an element of the financial statements where precise measurement is not possible.

## Impact on Loan Covenants

Many loan agreements contain covenants—legally binding requirements—based on ratios or other financial metrics derived from published financial statements. Accounting policy elections and estimates can affect reported performance and financial position, leading to different covenant outcomes even where the core business is unchanged.

> **Key Term: Loan covenant**  
> A clause in a loan agreement requiring the borrower to meet specified financial or operational conditions, such as ratio thresholds.

### **Worked Example 1.1**

A retailer takes out a bank loan with a covenant requiring a minimum current ratio of 1.2. At the year end, management must choose between two inventory valuation methods:

- **FIFO:** Current assets increase by \$800k.
- **Weighted average cost:** Current assets increase by \$700k.

Inventory is the only difference. Current liabilities total \$900k. Which method would help the entity avoid covenant breach if the current ratio is close to 1.2?

> **Answer:**  
> Under FIFO: (\$800k inventory + other current assets)/\$900k > (\$700k inventory + other current assets)/\$900k. If the original current ratio was below 1.2, using FIFO may increase it just enough to meet the minimum. Policy selection can therefore be used to influence covenant compliance.

## Manipulating Ratios Through Accounting Choices

Accounting choices can affect whether an entity appears to comply with — or breach — important ratios. Decisions with the most effect include:

- Capitalising or expensing development costs
- Selection of depreciation method (affecting profit and non-current assets)
- Recognition of provisions versus contingent liabilities
- Revaluation versus cost models for non-current assets
- Inventory valuation method (FIFO vs. weighted average)
- Lease classification (short-term/low-value exemptions under IFRS 16)

### **Worked Example 1.2**

An entity with a high gearing ratio wants to improve its measure ahead of a planned bond issue. It holds property on the cost model but could elect to revalue. How would this affect its reported gearing?

> **Answer:**  
> A revaluation increases non-current assets and, correspondingly, equity (through other comprehensive income). Debt remains unchanged. As a result, the debt/equity ratio decreases, reducing reported gearing. Users may perceive the entity as less risky, even though the core cash flow position is unaffected.

### **Exam Warning**

> In exam scenarios, do not assume that all ratio improvements are beneficial or that policy changes are always legitimate. If policy selection is motivated solely by the desire to meet ratios or covenants (rather than to provide useful information), this may breach ethical standards.

## Communication of Accounting Choices and Their Effects

Stakeholders, including lenders, shareholders, and regulators, rely on published financial information to make decisions. Accountants play a critical role in explaining and disclosing:

- Why a particular policy or estimate was chosen
- How that policy or estimate impacts ratios and metrics
- Whether a change in policy is justified by relevance or faithful representation, per IAS 8

Disclosure of significant policies, material estimation uncertainties, and the effects of changes must be clear in both narrative and numerical presentation.

> **Key Term: Ratio analysis**  
> The examination and interpretation of relationships between figures in the financial statements to assess performance, position, or risk.
>
> **Key Term: Earnings management**  
> The deliberate use of accounting choices or estimates to influence reported profit, position, or ratios, sometimes to mislead users or meet targets.

### **Worked Example 1.3**

Beta Ltd has a borrowing agreement with a bank. The agreement stipulates that if the EBITDA/interest cover ratio falls below 3.0, the bank may recall the loan. This year, management capitalises \$2m of development costs (which previously would have been expensed) and applies a straight-line depreciation policy instead of reducing balance, deferring more expenses. EBITDA rises above the threshold. Discuss the implications.

> **Answer:**  
> By capitalising development costs and altering depreciation, Beta Ltd defers expenses, increasing EBITDA. The higher ratio means they avoid a breach and possible loan recall, safeguarding liquidity, but also risk misleading users about true ongoing profitability and cash flow if not disclosed transparently.

## Risks and Professional Communication

While accounting policy flexibility exists, abusive earnings management or selective policy adoption to meet short-term external targets may:

- Undermine faithful representation
- Reduce comparability
- Erode user trust
- Trigger audit issues or regulatory scrutiny

Professional accountants must communicate objectively and avoid bias, documenting the rationale for policy selection and its impact on reported metrics.

### **Revision Tip**

> When communicating the effects of accounting choices, always reference the relevant IFRS requirements, ethical standards, and the need for clear and faithful representation in explanations.

## **Summary**

Accounting policy choices and estimation techniques can materially impact key ratios and covenants, affecting users’ decisions and an entity’s contractual obligations. While some level of flexibility is allowed, selection should always be faithful to economic reality and professionally communicated. Disclosure and transparency are essential, especially where choices impact debt agreements or stakeholder perceptions.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain how accounting policies and estimates affect financial ratios
- Discuss the role of accounting choice in meeting (or breaching) loan covenants
- Analyse the mechanisms by which accounting decisions influence stakeholder perception and contractual risk
- Communicate the rationale and impact of accounting policies in line with IFRS and professional ethics

## **Key Terms and Concepts**

- Accounting policy
- Accounting estimate
- Loan covenant
- Ratio analysis
- Earnings management

Analysis and professional communication - Impact of accounting choices on ratios and covenants