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.

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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.

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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.

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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.

 

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