IAS 1 Presentation of Financial Statements—Classification of debt with covenants as current or non-current (Agenda Paper 2)

Background

The Committee received informal feedback and enquiries concerning the different interpretations arising from the application of recent amendments to IAS 1 related to the classification of liabilities. The stakeholders asked how an entity determines whether it has "the right to defer settlement" when a long-term liability is subject to a condition and the borrower's compliance with the condition is tested at dates after the reporting date. The agenda paper analysed the application of the revised IAS 1:69(d) with regard to three cases with the condition tested at different dates. The staff asked if the Committee agrees with the analysis and the recommendation not to add a standard-setting project.

Staff analysis

The staff did not perform any outreach because they concluded that the matter could be prevalent and limited observable practice is expected because the effective date of the amendments has been deferred.

In all the three cases described, the staff considered that the entity is required to classify the loan as current because all the conditions have not been met at the end of the reporting period. Even if the lender does not test the compliance on that date, the staff emphasised the importance of IAS 1:72A that the entity's right to defer settlement of the loan for at least twelve months after the reporting date must exist at the end of the reporting date. Therefore, even if the entity expects to meet the condition at a later condition testing date, such expectation is not relevant if the condition is not met at the reporting date. Furthermore, when there are two conditions at two testing dates (one at report date and one at a later date) the requirement in IAS 1:72A is considered to be met only if the entity meets both conditions at the reporting date.

Some may argue that IAS 1:BC48E is relevant when an entity assesses whether it complies with a specified condition at end of the reporting period but the lender does not test compliance until a later date. Some suggested that the entity should adjust its working capital ratio (the condition required in the cases described) to reflect the effect of expected transactions to assess if such condition would be met at the subsequent lender's testing date. However, the staff are of the view that the adjustment mentioned in IAS 1:BC48E is referring to circumstances in which the entity's performance up to the reporting date reflects a shorter period than specified in the condition to be tested in a later date. Accordingly, IAS 1:C48E is relevant when the condition is performance but not if the condition is related to the entity's financial position.

Staff recommendation

Based on the above analysis, the staff concluded that the principles and requirements in the amendments to IAS 1 provide an adequate basis to determine the classification of a loan in the cases descried and not to add the matter to the Committee's standard-setting agenda.

Discussion

The Committee members generally agreed with the analysis of the three cases in the agenda paper and considered it a helpful exercise to understand the application of the amendments, particularly IAS 1:72A, and to decrease the diversity in practice. However, a number of the Committee members raised concerns on the interpretation of IAS 1:BC48E in the staff paper and in particular that the criteria may be too strict in circumstances when the financial ratio fluctuates due to seasonality or industry factors.

The staff said that the amendments intended to give a simple approach and certainty on how to do the test as at reporting date to bring consistency. Most of the Committee members understood the purpose but some raised concerns on the outcome of the amendments.

Some Committee members asked why IAS 1:BC48E cannot be applied to case 3 if the entity expects to meet the higher working capital ratio to be tested at a later date set by the lender due to seasonality or industry factors. Applying IAS 1:BC48E could help normalising the working capital at the reporting date, and it therefore makes more sense to consider the covenant to be met if the entity could meet the higher covenant at a later testing date based on past history. One Committee member questioned how it is interpreted that IAS 1:BC48E applies only to covenants related to profit or loss but not to the balance sheet. The staff replied that the basic principle in IAS 1:72A could not be overridden. IAS 1:BC48D elaborates the compliance of the condition as at the reporting date while IAS 1:BC48E intends to give guidance on a covenant related to cumulative financial performance measures so it results in like for like comparison. However, it does not aim to allow making an adjustment for expectations in relation to covenants related to the financial position.

One Committee member said that he is not comfortable with the result of switching the classification from current to non-current at subsequent reporting dates if the expectation regarding the ratio could not be applied at a later date. Moreover, it may result in structuring in order to meet the covenant at reporting date.

The Committee decided, by a majority vote of 13:1, not to add the matter to the Committee's standard-setting agenda, and all of the Committee members agreed with the drafting amendments proposed by staff in the meeting.