IFRS 2022 update – Classification of non-current liabilities with covenants – Best read

Overview – IFRS 2022 update – Classification of non-current liabilities with covenants

In October 2022, the IASB issued amendments that clarify that only covenants with which an entity must comply on or before the reporting date will affect a liability’s classification as current or non-current. IFRS 2022 update – Classification of non-current liabilities with covenants

Additional disclosures are required for non-current liabilities arising from loan arrangements that are subject to covenants to be complied with within twelve months after the reporting period.

The amendments will be effective for annual reporting periods beginning on or after 1 January 2024, with early application permitted. IFRS 2022 update – Classification of non-current liabilities with covenants

Why this change?

In January 2020, the IASB issued amendments to paragraphs 69 to 76 of IAS 1 (the 2020 amendments) to specify the requirements for classifying liabilities as current or non-current. A key requirement of the 2020 amendments was that entities with liabilities that are subject to covenants to be complied with at a date subsequent to the reporting period (“future covenants”) do not have the right to defer settlement of the liabilities at the end of the reporting period if they do not comply with the covenants at that date. IFRS 2022 update – Classification of non-current liabilities with covenants

Stakeholders were concerned about the impact of this proposal and, as a result, the IFRS Interpretations Committee (the Committee) published a tentative agenda decision (TAD) in December 2020 explaining how to apply the proposal to three fact patterns. The Committee agreed with the concerns raised in comment letters responding to the TAD about the consequences of the 2020 amendments for certain scenarios and reported them to the Board. On that basis, the Board proposed amendments in November 2021, which, after further adjustments, resulted in the amendments issued in October 2022 (the 2022 amendments). IFRS 2022 update – Classification of non-current liabilities with covenants

The 2022 amendments

Under the 2022 amendments, only covenants of a liability arising from a loan arrangement, which an entity must comply with on or before the reporting date affect the classification of that liability as current or non-current. The amendments are linked to the requirements on disclosure about such liabilities. The IASB concluded that the amended classification requirements will provide useful information when considered together with the requirements to disclose information about non-current liabilities with future covenants in the notes. IFRS 2022 update – Classification of non-current liabilities with covenants

Separarate presentation

The 2022 amendments, as opposed to the proposed amendments in the 2021 ED, do not require an entity to present separately non-current liabilities for which the entity’s right to defer settlement is subject to compliance with future covenants within twelve months. Instead, the 2022 amendments require entities to disclose information about such covenants and related liabilities in the notes.

Disclosures

The 2022 amendments require an entity to provide disclosure when a liability arising from a loan agreement is classified as non-current and the entity’s right to defer settlement is contingent on compliance with future covenants within twelve months.

This disclosure is required to include information about the covenants and the related liabilities. The disclosures must include information about the nature of the future covenants and when compliance is applicable, as well as the carrying amount of the related liabilities. IFRS 2022 update – Classification of non-current liabilities with covenants

The purpose of this information is to allow users to understand the nature of the future covenants and to assess the risk that a liability classified as non-current could become repayable within twelve months. Furthermore, if facts and circumstances indicate that an entity may have difficulty in complying with such covenants, those facts and circumstances must be disclosed.

For example, mitigating actions taken by the entity before or after the reporting period might be relevant to disclose as such facts and circumstances. Similarly, if the entity had not complied at the end of the reporting period with such future covenants, then disclosure of that fact might be appropriate.

Right to defer settlement

In the 2021 ED, the Board proposed to clarify what is meant by a right to defer settlement in paragraph 69(d) and the scope of the proposed requirements in paragraph 72B. Among other things, the ED introduced a notion of an event or outcome being ‘unaffected by the entity’s future actions’ to clarify situations in which an entity would not have a right to defer settlement of a liability. However, the feedback received suggested that the proposal would not achieve its objective.

Therefore, the IASB decided, instead, to specify that the requirements in paragraph 72B apply only to liabilities arising from loan arrangements. IFRS 2022 update – Classification of non-current liabilities with covenants

The Board concluded that the amended classification requirements will provide useful information when considered together with the requirements to disclose information about non-current liabilities with future covenants in the notes.

The 2020 amendments

Several of the 2020 amendments are not impacted by the 2022 amendments, of which two are summarised below. IFRS 2022 update – Classification of non-current liabilities with covenants

A requirement was added to clarify that the ‘classification of a liability is unaffected by the likelihood that the entity will exercise its right to defer settlement of the liability for at least twelve months after the reporting period’ (paragraph 75A). That is, management’s intention to settle in the short run does not impact the classification. This applies even if settlement has occurred when the financial statements are authorised for issuance.

The Board also added two new paragraphs (paragraphs 76A and 76B) to IAS 1 to clarify what is meant by ‘settlement’ of a liability. The Board concluded that it was important to link the settlement of the liability with the outflow of resources from the entity. Settlement by way of an entity’s own equity instruments is considered settlement for the purpose of classification of liabilities as current or non-current, with one exception. If, and only if, the conversion option itself is classified as an equity instrument would settlement by way of own equity instruments be disregarded when determining whether the liability is current or non-current.

For further information on the 2020 amendments, see IFRS Developments Issue 159: Amendments to classification of liabilities as current or non-current (Updated July 2020).

What’s new compared to the current IAS 1

The main changes from current IAS 1 due to the 2020 amendments and 2022 amendments are set out below:

Right to defer settlement must exist at reporting date and have substance

Under existing IAS 1 requirements, companies classify a liability as current when they do not have an unconditional right to defer settlement for at least 12 months after the reporting date. The International Accounting Standards Board (IASB) has removed the requirement for a right to be unconditional and instead now requires that a right to defer settlement must exist at the reporting date and have substance.

Similar to existing requirements in IAS 1, the classification of liabilities is unaffected by management’s intentions or expectations about whether the company will exercise its right to defer settlement or will choose to settle early.

Liabilities with covenants – Classification criteria clarified and new disclosures

A company will classify a liability as non-current if it has a right to defer settlement for at least 12 months after the reporting date. This right may be subject to a company complying with conditions (covenants) specified in a loan arrangement.

After reconsidering certain aspects of the 2020 amendments1, the IASB reconfirmed that only covenants with which a company must comply on or before the reporting date affect the classification of a liability as current or non-current.

Covenants with which the company must comply after the reporting date (i.e. future covenants) do not affect a liability’s classification at that date. However, when non-current liabilities are subject to future covenants, companies will now need to disclose information to help users understand the risk that those liabilities could become repayable within 12 months after the reporting date. See Example 1.

Convertible debt may become current

The amendments also clarify how a company classifies a liability that can be settled in its own shares – e.g. convertible debt.

When a liability includes a counterparty conversion option that involves a transfer of the company’s own equity instruments, the conversion option is recognised as either equity or a liability separately from the host liability under IAS 32 Financial Instruments: Presentation. The IASB has now clarified that when a company classifies the host liability as current or non-current, it can ignore only those conversion options that are recognised as equity.

IFRS 2022 update – Classification of non-current liabilities with covenants

Companies may have interpreted the existing IAS 1 requirements differently when classifying convertible debt. Therefore, convertible debt may become current (see Example 2).

Transition and effective date

The amendments will be effective for annual reporting periods beginning on or after 1 January 2024 and will need to be applied retrospectively in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Early adoption is permitted, but will need to be disclosed.

The effective date of the 2020 amendments is accordingly delayed, from reporting periods beginning on or after 1 January 2023 to reporting periods beginning on or after 1 January 2024. Early application of the 2020 amendments is permitted. However, an entity that applies the 2020 amendments early is also required to apply the 2022 amendments, and vice versa.

Example 1

Loan subject to covenants

The case:

  • A company has a loan that is repayable in five years.
  • The loan includes a covenant requiring a working capital ratio (WC-ratio) of at least 1.2 on 31/12/2024 and 1.5 on 30/06/2025. The loan becomes repayable on demand if the ratio is not met on any of the specified covenant testing dates.
  • The company is preparing its annual financial statements for the year ending 31/12/2024. The WC-ratio at 31/12/2024 is 1.3 and the company expects the ration to be 1.4 at 30/06/2025.

The impact in summary:

Loan covenant test Impact classification at 31/12/2024
Reporting date WC-ratio of at least 1.2 (tested at 31/12/2024) Yes. Beacuse the company complies with the covenant at the reporting date, it will classify the loan as non-current.
Future covenant WC-ratio of at least 1.5 (tested at 30/06/2025) No. Covenants that the company must comply with after the new reporting date do not affect the classification of the loan at the reporting date. However, new disclosures will apply.
Futire expectation WC-ratio of 1.4 (expected at 30/06/2025) No. Management’s expecttation of complinace with the future covenant is irrelevant for classification purposes, but disclosures will apply.

Example 2

Foreign curency convertible bond

The case:

  • A foreign vurrency convertible bond will mature on 31/12/2027.
  • The bond comprises a financial liability and an option granted to the holder to conevrt the bond into a fixed number of the company’s ordinary shares at any time before maturity.
  • The conversion option does not meet the definition of an equity instrument because it fails the ‘fixed-for-fixed’ criteria and is an embedded derivative recognised separately from the host liability.

Classification under existing requirements

Classification under the amended IAS 1 paragraphs

Mixed practice

Current IAS 1 Presenation of financial statements is unclear.

Current

The transfer of the company’s own equity instruments is a form of settlement.

As the holder has an option to convert the host liability into the company’s own equity instruments at any time before maturity, the company does not have the right to defer settlement for at least twelve months from the reporting date.

Therefore, the host liability is classified as current.

 

IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities wi

IFRS 2022 update – Classification of non-current liabilities with covenantsth covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants IFRS 2022 update – Classification of non-current liabilities with covenants

IFRS 9 Best long-read SPPI Test

The SPPI Test

If an asset is in a hold-to-collect or hold-to-collect or sell business model, an entity assesses whether the cash flows from the financial asset meet the ‘solely payments of principal and interest’ (SPPI Test) benchmark – i.e. whether the contractual terms of the financial asset give rise, on specified dates, to cash flows that are solely payments of principal and interest.

  • Principal’ is the fair value of the financial asset on initial recognition. The principal may change over time – e.g. if there are repayments of principal.
  • Interest’ is consideration for the time value of money and credit risk. Interest can also include consideration for other basic lending risks and costs, and a profit margin.

A financial asset that does not meet the SPPI Test is always measured at FVPL, unless it is a non-trading equity instrument and the entity makes an irrevocable election to measure it at FVOCI. Here is the decision tree to put the narrative in context:

SPPI Test

Contractual cash flows that meet the SPPI Test are consistent with a basic lending arrangement in the banking industry.

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Low credit risk operational simplification

Low credit risk operational simplification

IFRS 9 contains an important simplification that, if a financial instrument has low credit risk, then an entity is allowed to assume at the reporting date that no significant increases in credit risk have occurred. The low credit risk concept was intended, by the IASB, to provide relief for entities from tracking changes in the credit risk of high quality financial instruments. Therefore, this simplification is only optional and the low credit risk simplification can be elected on an instrument-by-instrument basis.

This is a change from the 2013 ED, in which a low risk exposure was deemed not to have suffered significant deterioration in credit risk. The amendment to make the simplification optional was made in response to requests from constituents, including regulators. It is expected that the Basel Committee SCRAVL consultation document will propose that sophisticated banks should only use this simplification rarely for their loan portfolios.

For low risk instruments, the entity would recognise an allowance based on 12-month ECLs. However, if a financial instrument is not considered to have low credit risk at the reporting date, it does not follow that the entity is required to recognise lifetime ECLs. In such instances, the entity has to assess whether there has been a significant increase in credit risk since initial recognition that requires the recognition of lifetime ECLs.

The standard states that a financial instrument is considered to have low credit risk if: [IFRS 9.B5.22]

  • The financial instrument has a low risk of default
  • The borrower has a strong capacity to meet its contractual cash flow obligations in the near term
  • Adverse changes in economic and business conditions in the longer term may, but will not necessarily, reduce the ability of the borrower to fulfil its contractual cash flow obligations Low credit risk operational simplification

A financial instrument is not considered to have low credit risk simply because it has a low risk of loss (e.g., for a collateralised loan, if the value of the collateral is more than the amount lent (see collateral) or it has lower risk of default compared with the entity’s other financial instruments or relative to the credit risk of the jurisdiction within which the entity operates.

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Payment holidays on loans

Payment holidays on loans under IFRS 9

Governments and banks have introduced payment deferral programs to support borrowers affected by Covid-19. But deferred payments are not forgiven and must be repaid in the future, raising prospective risks to the banking system. Thus, they should be designed to balance near-term economic relief benefits with longer-term financial stability considerations.

The Basel Committee on Banking Supervision (BCBS) and several prudential authorities have issued statements clarifying how payment deferrals should be considered in assessing credit risk under applicable accounting frameworks. These measures aim to encourage banks to continue lending, to avert an even deeper recession.

Prudential authorities are caught “between a rock and a hard place” as they encourage banks – through various relief measures – to provide credit to solvent, but cash-strapped borrowers, while keeping in mind the longer-term implications of these measures for the health of banks and national banking systems.

In navigating these tensions, banks and supervisors face a daunting task as borrowers that may be granted payment holidays have varying risk profiles. Distinguishing between illiquid and insolvent borrowers – amidst an uncertain outlook – should help guide banks’ efforts to support viable borrowers, while preserving the integrity of their reported financial metrics.

What is this all about?

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IFRS 16 Leases presentation in cash flows – Complete easy read

IFRS 16 Leases presentation in cash flows

Most changes from IAS 17/IFRIC 4 to IFRS 16 relate to lessees, the companies renting a car, office or warehouse.

At first, IFRS 16 has affected balance sheet and balance sheet-related ratios such as the debt/equity ratio. Aside from this, IFRS 16 also influenced the income statement, because an entity now has to recognise interest expense on the lease liability (obligation to make lease payments) and depreciation on the ‘right-of-use’ asset (that is, the asset that reflects the right to use the leased asset).

Due to this, for lease contracts previously classified as operating leases the total amount of expenses at the beginning of the lease period will be higher than under IAS 17. Another consequence of the changes in presentation is that EBIT and EBITDA will be higher for companies that have material operating leases.

IFRS 16 also changes the cash flow statement. Lease payments that relate to contracts that have previously been classified as operating leases are no longer presented as operating cash flows in full. Only the part of the lease payments that reflects interest on the lease liability can be presented as an operating cash flow (depending on the entity’s accounting policy regarding interest payments).

Cash payments for the principal portion of the lease liability are classified within financing activities. Payments for short-term leases, leases of low-value assets and variable lease payments not included in the measurement of the lease liability remain presented within operating activities.

Presentation and disclosures

In the statement of cash flows, lease payments are classified consistently with payments on other financial liabilities:

  • The part of the lease payment that represents cash payments for the principal portion of the lease liability is presented as a cash flow resulting from financing activities.
  • The part of the lease payment that represents interest portion of the lease liability is presented either as an operating cash flow or a cash flow resulting from financing activities (in accordance with the entity’s accounting policy regarding the presentation of interest payments).
  • Payments on short-term leases, for leases of low-value assets and variable lease payments not included in the measurement of the lease liability are presented as an operating cash flow.

A simple example to classify the movements in Right-of-use assets is as follows:

IFRS 16 Leases presentation in cash flows

A simple example to classify the movements in Lease liabilities is as follows:

IFRS 16 Leases presentation in cash flows

On the balance sheet, the right-of-use asset can be presented either separately or in the same line item in which the underlying asset would be presented. The lease liability can be presented either as a separate line item or together with other financial liabilities. If the right-of-use asset and the lease liability are not presented as separate line items, an entity discloses in the notes the carrying amount of those items and the line item in which they are included.

In the statement of profit or loss and other comprehensive income, the depreciation charge of the right-of-use asset is presented in the same line item/items in which similar expenses (such as depreciation of property, plant and equipment) are shown. The interest expense on the lease liability is presented as part of finance costs. However, the amount of interest expense on lease liabilities has to be disclosed in the notes.

IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows IFRS 16 Leases presentation in cash flows

IFRS 16 Leases presentation in cash flows

Country-by-Country tax reporting IAS 12 Risk or Profit

Country-by-Country tax reporting

Country-by-Country tax reporting has become a fact of life for multinational enterprises (MNEs) with worldwide revenue above EUR 750 million.

While most MNEs have developed processes to gather and report the required information, how well are they managing the risk associated with the Report?

Have they integrated the reporting process into their ongoing transfer pricing management and documentation?

Is the information generated by the reporting process consistent with the intent of their global transfer pricing policy?

Action 13 of the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan introduced a CbC reporting template which certain multinational enterprises (MNE) are required to complete and submit (usually) to the tax authority in their home country.

Following a consultation process, the template was published in September 2014 and was finalised on October 5, 2015 when the OECD also published final implementation guidance.

The final OECD report recommended that CbC reporting commence for periods starting on or after January 1, 2016. In general, multinationals with consolidated group revenue of less than EUR 750 million (or equivalent in local currency) in the prior financial year are exempted from filing the CbC Report.

However, for those not exempt, filing with the parent country tax authority is typically due within 12 months of the group’s financial year-end. If the country of the MNE parent does not require reporting, it is the responsibility of the MNE to designate a surrogate parent in a country where the CbC Report can be filed.

One of the main reasons that tax authorities implemented the CbC reporting requirement was to gain a better understanding of a multinational group’s activities, value drivers, profit creation, and taxes paid in each of the jurisdictions in which it operates.

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Uncertain tax treatments in IAS 12 and IFRIC 23

Uncertain tax treatments

Uncertain tax treatments – In short

Neither IAS 12 Income Taxes nor IFRIC 23 Uncertainty over Income Tax Treatments (the Interpretation) contain explicit requirements on the presentation of uncertain tax liabilities or assets in the statement of financial position.

This has led to diversity in practice. Some entities present uncertain tax liabilities as current (or deferred) tax liabilities and others include these balances within another line item such as provisions.

In September 2019, in response to a request for clarification on this matter, the IFRS Interpretations Committee (the IFRS IC or the Committee) published an agenda decision. The Committee concluded that an entity is required to present uncertain tax liabilities as current tax liabilities or deferred tax liabilities; and uncertain tax assets as current tax assets or deferred tax assets.

Based on an earlier agenda decision, the impact of uncertain tax treatments that meet the definition of income taxes should be presented in the statement of profit or loss in the line item ‘tax expense’.

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What is the most important disclosure definition under IAS 1?

What is the disclosure definition under IFRS?

Disclosure definition – one of the best ways to explain the need for disclosures is provided in IAS 1.119management considers whether disclosure would assist users in understanding how transactions, other events and conditions are reflected in reported financial performance and financial position. Each entity considers the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity.

Let us point to some IFRS disclosure particularities

In IAS 1 Presentaion of Financial Statements the overall disclosure requirements are provided. Other IAS/IFRSs set out the recognition, measurement and disclosure requirements for specific transactions and other events (IAS 1.3).

An entity cannot rectify inappropriate accounting policies either by disclosure of the accounting policies used or by notes or explanatory material (IAS 1.18).

Some IAS/IFRSs specify information that is required to be included in the financial statements, which include the notes. An entity need not provide a specific disclosure required by a IFRS if the information resulting from that disclosure is not material. This is the case even if the IFRS contains a list of specific requirements or describes them as minimum requirements.

An entity shall also consider whether to provide additional disclosures when compliance with the specific requirements in IFRS is insufficient to enable users of financial statements to understand the impact of particular transactions, other events and conditions on the entity’s financial position and financial performance (IAS 1.31).

Minimum comparative information

In some cases, narrative information provided in the financial statements for the preceding period(s) continues to be relevant in the current period. For example, an entity discloses in the current period details of a legal dispute, the outcome of which was uncertain at the end of the preceding period and is yet to be resolved. Users may benefit from the disclosure of information that the uncertainty existed at the end of the preceding period and from the disclosure of information about the steps that have been taken during the period to resolve the uncertainty (IAS 1.38B).

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IRR How to calculate

IRR How to calculate

The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.

When calculating IRR, expected cash flows for a project or investment are given and the NPV equals zero. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flows of that investment. (Cost paid = present value of future cash flows, and hence, the net present value = 0).

Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater than or equal to the cost of capital, the company would accept the project as a good investment. (That is, of course, assuming this is the sole basis for the decision).

In reality, there are many other quantitative and qualitative factors that are considered in an investment decision). If the IRR is lower than the hurdle rate, then it would be rejected, if IRR is the only investment consideration.

Under IFRS 16 ‘Leases’, a similar calculation is used to calculate discount rates are used to determine the present value of the lease payments used to measure a lessee’s lease liability. Discount rates are also used to determine lease classification for a lessor and to measure a lessor’s net investment in a lease.

For lessees, the lease payments are required to be discounted using:

For lessors, the discount rate will always be the interest rate implicit in the lease.

The interest rate implicit in the lease is defined in IFRS 16 as ‘the rate of interest that causes the present value of (a) the lease payments and (b) the unguaranteed residual value to equal the sum of (i) the fair value of the underlying asset and (ii) any initial direct costs of the lessor.’

The lessee’s incremental borrowing rate is defined in IFRS 16 as ‘the rate of interest that a lessee would have to pay to borrow over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset in a similar economic environment’.

The incremental borrowing rate is determined on the commencement date of the lease. As a result, it will incorporate the impact of significant economic events and other changes in circumstances arising between lease inception and commencement.

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IFRS 15 Pre-Contract Establishment Date activities – Important to know

Pre-Contract Establishment Date activities

or

Partially Satisfied Performance Obligations Before the Identification of a Contract

Entities sometimes begin activities on a specific anticipated contract with their customer before (1) the parties have agreed to all of the contract terms or (2) the contract meets the criteria in step 1 (see Step 1 Identify the contract) of IFRS 15. The IASB staff refer to the date on which the contract meets the step 1 criteria as the “contract establishment date” (CED) and refer to activities performed before the CED as “pre-CED activities.”

TRG Update — Pre-CED Activities

The FASB and IASB staffs noted that stakeholders have identified two issues with respect to pre-CED activities:

  • How to recognize revenue from pre-CED activities.
  • How to account for certain fulfillment costs incurred before the CED.

The TRG discussed these issues in March 2015.

TRG members generally agreed with the staffs’ conclusion that once the criteria in step 1 have been met, entities should recognize revenue for pre-CED activities on a cumulative catch-up basis (i.e., record revenue as of the CED for all satisfied or partially satisfied performance obligations) rather than prospectively because cumulative catch-up is more consistent with the new revenue standard’s core principle.

The two Q&A below demonstrates the application of the TRG’s general agreement.

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