Companies have for many years struggled to correctly classify certain bank loans and borrowings as either current or non-current liabilities. One of the complaints I often hear is that the classification of liabilities is a rules-based assessment that does not reflect management’s expectations or the likelihood of repayment.
Accounting standards required that an entity must have an unconditional right to defer settlement of a liability for at least 12 months after balance date for it to be classified as a non-current liability. Without this right an entity might be unable to avoid having to repay the liability within 12 months of its reporting date.
It would be unusual for an entity’s right to defer settlement of a liability for more than 12 months to be unconditional – there would usually be some trigger or event (no matter how likely) that could require earlier repayment. The International Accounting Standards Board (IASB) amended this requirement in 2020 by replacing an ‘unconditional right to defer’ with ‘a right to defer’ and attempted to clarify how an entity assesses whether it has the right to defer settlement of a liability when that right is subject to compliance with specified conditions (often referred to as ‘covenants’) within 12 months after the reporting date. According to the 2020 amendments, an entity has a right to defer settlement only if it would have complied with covenants based on its circumstances at balance date, even though compliance is only required after that date. So even with the 2020 amendments, the IASB applied a hypothetical, rules-based test which ignored the likelihood, or management expectations, of repayment within 12 months.
Not long after the 2020 amendments were made, different interpretations of how those rules would apply in practice started to emerge. The IFRS Interpretations Committee attempted to clarify the IASB’s 2020 amendments by issuing a series of examples to illustrate how they would work in practice. Unfortunately, that just made matters worse. One of the examples IFRIC gave was:
“A company has a loan repayable in five years. The loan includes a covenant requiring a working capital ratio above 1.0 on 30 June 2022. The loan becomes repayable on demand if the ratio is not met at that specified date.
The company reports on 31 December 2021. At that date, the company’s working capital ratio is 0.9. Management expects to meet the minimum working capital ratio by the date on which it is required (30 June 2022).
At the reporting date, the company would not have complied with the covenant required within 12 months of that date — it has a working capital ratio of 0.9; the covenant requires a ratio above 1.0 on 30 June 2022. Applying the 2020 amendments, the company does not have a right to defer settlement at the reporting date — and thus classifies the liability as current.”
A consequence was that the 2020 amendments would require an entity to classify a liability as current even when, at the reporting date, it has no contractual obligation to repay the liability within 12 months and was not expected to breach its covenants at the future testing date. The above scenario could occur quite frequently, especially for businesses with seasonal operations and cash flows. Once practitioners started to realise that the 2020 amendments did not appropriately resolve the problems with the original standard and may not faithfully reflect an entity’s liquidity and working capital, the IASB was forced to revisit the standard once again in its latest Exposure Draft ED/2021/9 Non-current Liabilities with Covenants.
So, is it third time lucky?
In some situations although an entity may have no contractual obligation to repay a liability within 12 months of the reporting date, the entity’s right to defer settlement is not absolute — the liability could become repayable within 12 months depending on whether the entity complies with covenants after the reporting date. The IASB now acknowledges that in such situations it is impossible to know at the reporting date when the liability will ultimately be repayable.
To require such liabilities to be classified as current when it could equally be argued they should be non-current challenges the concept that financial statements should faithfully present the substance of transactions and events in a way that is neutral and free of error.
As a result, the IASB has now proposed two alternatives:
- Where an entity is required to comply with covenants and conditions on or before balance date it would classify liabilities as current or non-current based on its compliance with those covenants at balance date. For example, if an entity had to meet a working capital or EBITA covenant at year end and it met those tests at year end, the liability would be classified as non-current. If it failed the test, the liability would be classified as current unless it had received a waiver from the lender before balance date; or
- If an entity is required to comply with the condition only within 12 months after balance date (for example, a covenant based on the entity’s financial position six months after the end of the reporting period), that condition does not affect whether the liability is classified as current or non-current. However, it would have to present separately those non-current liabilities subject to covenants on the face of its balance sheet and disclose information relating to those conditions in the notes.
On the face of it this seems a more sensible outcome. Covenants that are to be tested on or before balance date will identify if the entity has passed those tests and whether the borrower has a right to defer settlement for more than 12 months after balance date. Where a covenant is only tested at a future date, the liability could be classified as non-current but is presented separately from other liabilities on the balance sheet and additional disclosures will provide information relating to those conditions and how the entity expects to comply with them in the future.
Nevertheless, we still harbour some concerns with the new proposals. It is common for Australian retail banks to include ‘material adverse change’ or similar clauses within their general lending terms and conditions. Events or conditions giving rise to a material adverse change is usually determined by the lender and generally represents a default event which permit the lender to require immediate repayment of outstanding balances.
A lender’s assessment that a material adverse change exists can occur at any time and is not limited to a single annual assessment. In addition, the lender should have a reasonable basis for that assessment and does not have absolute discretion to require repayment of the loan at any time. A broad reading of the IASB’s proposal suggests that these clauses should not affect the classification of borrowings as non-current liabilities. But there is some uncertainty based on the IASB’s specific drafting of the requirements and we will be asking the IASB to clarify how its proposals would apply to material adverse change clauses. We encourage our clients to review their borrowing agreements and consider how the classification of those borrowings could be affected by ED/2021/9. Submissions on the IASB’s exposure draft close on 21 March 2022.
Will the IASB’s 2022 amendments finally result in a sensible financial reporting outcome for Australian corporate borrowers? As my mother would often answer when we were kids, “we’ll see”.