Insight

Amendments to classification of liabilities (IAS®1)

Current or noncurrent classification of liabilities could change, affecting covenants compliance

Kevin Bogle

Kevin Bogle

IFRS Institute Advisory Leader, KPMG US

+1 212-872-5766

From the IFRS Institute – February 28, 2020

The International Accounting Standards Board recently issued revised guidance for classifying liabilities as current versus noncurrent – focusing on a company’s right to defer settlement at the reporting date. This means the company’s intent to defer is ignored. Subsequent events, such as obtaining a bank waiver for a covenant violation or refinancing after the reporting date, continue to be disregarded. Certain convertible bonds may now need to be classified as current. The amendments apply from 2022, retrospectively, but could impact compliance with debt covenants and require companies to act now to renegotiate debt agreements. Significant differences with US GAAP continue to exist.

Right to defer settlement: Change from ‘unconditional’ right to ‘substantive’ right

Existing guidance in IAS 11 requires a company to classify a liability as current unless, among other things, the company has an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. It also requires a company to classify as noncurrent a liability that the company expects, and has the discretion, to refinance or roll over for at least 12 months after the reporting period, under an existing loan facility. These requirements have caused confusion and resulted in diversity in practice, making it difficult for users to understand and compare financial statements.

The amendments clarify that the classification of liabilities as current or noncurrent is based solely on the company’s right to defer settlement at the end of the reporting period. The company’s right to defer settlement for at least 12 months from the reporting date need not be unconditional, but must have substance.

The classification is not affected by management’s intentions or expectations about whether and when the company will exercise its right.

If the right to defer settlement is subject to the company complying with specified conditions – e.g. bank covenants as illustrated in Example 1 below – the right exists at the end of the reporting period only if the company complies with those conditions at that date. This is so even if the lender does not test compliance until a later date. And if a covenant is breached after the reporting date but before the financial statements are issued, the liability is classified as noncurrent.

There is limited guidance on how to determine whether a right has substance and the assessment may require management to exercise judgment. Consistent with existing guidance in IAS 1, the company’s disclosures about the timing of settlement should help users understand the impact of the liability on the company’s financial statements and relevant financial ratios.

Fact patterns

Example 1: Term loan of 1 million
  • Five-year term loan
  • Fully drawn down at October 1, 2020, with a due date of September 30, 2025
  • Annual covenant test based on information at September 30 that renders loan repayable on demand if breached.
Example 2: Rollover facility of 1 million
  • Five-year facility
  • Fully drawn down at October 1, 2020 as a one-year loan, with an intent to rollover on October 1, 2021
  • Ability to rollover loan is conditional on compliance with the same covenant test as in Example 1.

How is the loan classified on December 31, 2020 (the reporting date)?

Classification under existing guidance in IAS 1

Noncurrent

The loan is not due for settlement in the coming 12 months, either in accordance with its maturity or because of breaches of the covenant that exist at the reporting date.

The existence or probability of breaches after the reporting date are irrelevant.

Current

The rollover facility only gives the company a right to avoid repayment if it meets certain conditions at a future date. In other words, under an existing criterion (paragraph 69(d) of IAS 1), the right is not ‘unconditional’ and the liability is classified as current.

Classification after the amendments

Noncurrent

The same analysis and conclusion still apply.

Potentially noncurrent

At the reporting date, the company has the right to roll over the facility at a future date. This right is conditional on compliance with covenants at a future date.

The amount drawn down under the rollover facility may potentially be classified as noncurrent, like the term loan in Example 1 that is economically similar. However, this will depend on whether this right has substance. Assessing if a right has substance requires judgment.

Assuming the right has substance, the liability is classified as noncurrent if the company complies with the covenant test at the reporting date, even though the lender will not test compliance until later.

 

Clarifying the term ‘settlement'

The amendments clarify that the transfer of the company’s own equity instruments is regarded as settlement of a liability, unless it results from the exercise of a conversion option that meets the definition of an equity instrument. This means that if the conversion option is recognized separately from the liability as an equity component of a compound financial instrument, the transfer of the company’s own equity does not impact the convertible debt’s classification as current or noncurrent.

Conversely, a convertible debt that the holder may convert to equity before maturity (and within 12 months of the reporting date) is classified as current if that conversion option is a derivative liability under IAS 322. Such instruments include bonds with holder conversion options that are separated as an embedded derivative from the host liability, and instruments that mandate settlement in a variable number of equity instruments.

This may represent a significant change for companies that currently only consider the date at which a cash payment is required – i.e. the issuance of equity instruments is not considered settlement of the liability for the purpose of balance sheet classification.

The following table summarizes potential differences in applying the current guidance versus the amendments:

Fact pattern


Example 3: Foreign currency convertible bond

  • Foreign currency convertible bond matures on December 31, 2023.
  • Bond comprises a financial liability and an option granted to the holder to convert the bond into a fixed number of the company’s ordinary shares at any time before maturity.
  • Conversion option does not meet the definition of an equity instrument because it failed the ‘fixed-for-fixed’ criteria and is an embedded derivative recognized separately from the host liability.

How is the host liability classified on December 31, 2020 (the reporting date)?

Classification under existing guidance in IAS 1


IAS 1 is unclear and practice is mixed.
 

Classification after the amendments

Current

The transfer of the company’s own equity instruments is a form of settlement. Because the holder has an option to convert the host liability into the company’s own equity instruments at any time before maturity (which does not meet the definition of an equity instrument), the company does not have the right to defer settlement for at least 12 months from the reporting date.


More broadly, the accounting application continues to be counterintuitive in certain situations because of the exclusive focus on contractual terms and the borrower’s rights as of the reporting date.

For example, a company in strong financial health may have more debt classified as current despite it having secured long-term financing after the reporting date but before the financial statements are issued. Conversely, a company with poor financial health may have more noncurrent debt despite the probability being high of violating a debt covenant soon after the reporting date (or even when it has actually violated a debt covenant before issuing its financial statements).

IFRS® Standards vs. US GAAP (IAS 1 vs. ASC 4703)

The current and noncurrent classification of liabilities is not currently converged between IFRS Standards and US GAAP. IFRS Perspectives: Current and noncurrent debt classification (IAS 1 vs. ASC 470) provides a summary of existing differences between the two standards. IAS 1 focuses on the conditions – e.g. contract breaches and waivers – existing at the reporting date, while US GAAP considers subsequent events up to the date the financial statements are issued or ready for issuance. Unlike IFRS Standards, US GAAP requires, in certain situations, a likelihood assessment at the reporting date as to whether the creditor will accelerate repayment of the debt (e.g. in the case of subjective acceleration clauses).

US GAAP is complex in this area and the FASB intends to simplify existing requirements. The FASB issued a revised Exposure Draft4 in 2019. The basis for conclusions states that the proposed amendments should bring US GAAP and IFRS Standards closer, but differences would remain for classifying debt arrangements. Further decisions made by the FASB on amendments to ASC 470 could ultimately affect consistency between the two standards.

Transition and effective date

The amendments to IAS 1 are effective for annual periods beginning on or after January 1, 2022 and should be applied retrospectively. However, companies need to consider including IAS 85 disclosures in their next annual financial statements. Early application is permitted.

The takeaway

The amendments could make the current and noncurrent classification of liabilities easier by removing judgments about future events. But they also introduce new judgments about the substantiveness of the right to defer settlement. The classification of rollover facilities could change from current to noncurrent, while certain liabilities with equity-settlement features may change from noncurrent to current. Although the lead time to the effective date seems long, companies should allow sufficient time to revisit debt agreements to avoid breaching compliance with loan covenants.

Contributing authors

Mahesh Narayanasami

Mahesh Narayanasami

Partner, Dept. of Professional Practice, KPMG US

+1 212-954-7355
Valerie Boissou

Valerie Boissou

Partner, Dept. of Professional Practice, KPMG US

+1 212-954-1723
Rika Tanaka

Rika Tanaka

Managing Director, Dept. of Professional Practice, KPMG US

+1 212-954-6291

Footnotes

IAS 1, Presentation of Financial Statements 

IAS 32, Financial Instruments: Presentation

ASC 470, Debt

Simplifying the Classification of Debt in a Classified Balance Sheet

IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, para 30–31

 

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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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