Changes to how companies classify liabilities could affect loan covenants.
To promote consistency in application and clarify the requirements on determining if a liability is current or non-current, the International Accounting Standards Board (the Board) has amended IAS 11.
Companies should revisit their loan agreements to determine whether the classification of their loan liabilities will change – for example, convertible debt may need to be reclassified as ‘current’. Any changes could have a knock-on effect on covenant compliance. With potentially significant impacts ahead, companies are encouraged to take action now.
Under existing IAS 1 requirements, companies classify a liability as current when they do not have an unconditional right to defer settlement of the liability for at least twelve months after the end of the reporting period. As part of its amendments, the Board has removed the requirement for a right to be unconditional and instead, now requires that a right to defer settlement must have substance and exist at the end of the reporting period.
There is limited guidance on how to determine whether a right has substance and the assessment may require management to exercise interpretive judgement.
The existing requirement to ignore management’s intentions or expectations for settling a liability when determining its classification is unchanged.
A company classifies a liability as non-current if it has a right to defer settlement for at least twelve months after the reporting period.
The Board has now clarified that a right to defer exists only if the company complies with conditions specified in the loan agreement at the end of the reporting period, even if the lender does not test compliance until a later date.
This new requirement may change how companies classify their debt. How the new requirements (in particular IAS 1.72A) will apply to financial liabilities is unclear. It may change current practice and result in more debt being classified as current.
In its recent tentative agenda decision2, the IFRS Interpretations Committee clarifies how the amendments apply to term loans with covenants related to financial position and uses term loan examples to illustrate how a company would apply the amendments.
The amendments state that settlement of a liability includes transferring a company’s own equity instruments to the counterparty.
In light of this, the amendments clarify how a company classifies a liability that includes a counterparty conversion option, which could be recognised as either equity or a liability separately from the liability component under IAS 323. Generally, if a liability has any conversion options that involve a transfer of the company’s own equity instruments, these would affect its classification as current or non-current. The Board has now clarified that – when classifying liabilities as current or non-current – a company can ignore only those conversion options that are recognised as equity.
Therefore, companies may need to reassess the classification of liabilities that can be settled by the transfer of the company’s own equity instruments – e.g. convertible debt.
The amendments apply retrospectively for annual reporting periods beginning on or after 1 January 2023. Earlier application is permitted.
Although the amendments are not effective until 2023, companies will need to consider including IAS 84 disclosures in their next annual financial statements.
1 IAS 1 Presentation of Financial Statements
2 Classification of Debt with Covenants as Current or Non-current (IAS 1)
3 IAS 32 Financial Instruments: Presentation
4 IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, paragraphs 30-31