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IAS 1 — Classification of Debt with Covenants as Current or Non-current (Agenda Paper 3)

Date recorded:

Background

In its December 2020 meeting, the Committee discussed the informal feedback and enquiries received 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 and concluded that the entity is required to classify the loan as current in all cases because the entity does not have the right at the end of the reporting period to defer settlement of the loan for at least twelve months after the reporting period. The Committee members generally agreed with the conclusions but raised concerns on the interpretation of IAS 1:BC48E.  

36 comment letters were received and most respondents agreed or did not disagree with the analysis and the conclusion on how the revised IAS 1 should be interpreted in all three cases. However, almost all of these respondents expressed concerns about the outcome of applying the IAS 1 amendments and suggested that it be referred to the Board instead of finalising the agenda decision. The remaining respondents disagreed with the technical analysis in at least one of the cases presented in the tentative agenda decision.

Staff analysis

Some respondents disagreed with the staff’s analysis of the application of the requirements in IAS 1:72A to Case 2 and 3. They considered IAS 1:72A applies only to conditions requiring a specific ratio to be calculated using figures as at the end of the reporting period but tested at a later date and that does not mean the entity must comply with the loan conditions at a subsequent date. However, the staff explained that IAS 1:72A refers not only to conditions with which the entity is required to comply on or before the reporting date, but to any condition to which the right to defer settlement is subject to. The right exists only if the entity complies with all those conditions, but not only those that apply on or before the reporting date.

Similar to the concerns raised by the Committee members in the December 2020 meeting, a few respondents said it is unclear why the adjustments in IAS 1:BC48E are not allowed when assessing conditions based on the entity's financial position. The staff continued to support their view that IAS 1:BC48E is not relevant in these fact patterns because it is clear that the Board's intention is to address particular conditions based on the entity's financial performance for a period extending beyond the reporting period, but not to address conditions related to the entity’s financial position.

While not explicitly disagreeing, almost all of the respondents raised concerns about the outcome of applying the IAS 1 amendments to at least one of the cases, particularly Cases 2 and 3. Classifying the liabilities as current does not reflect the intention behind the contract and its design and does not reflect the contractual rights and obligations of the parties. Some of these respondents said the amendments could cause other challenges. For instances, classifying a liability as current before legal breach occurs could trigger current classification of other liabilities and could negatively affect the entity in various commercial aspects. In view of these issues, the respondents suggested that the Board reconsider the requirements of the amendments before they become effective. A few suggested (i) changing the requirements so that an entity would classify liabilities as current or non-current either based on management's expectations about the entity's compliance with conditions to be tested after the reporting period; or (ii) based only on compliance with conditions that are tested on or before the end of the reporting period. However, the staff said, in the process of developing the IAS 1 amendments, the Board had already received and considered views similar to those expressed by respondents and decided not to take these into account when finalising the amendments.

On the other hand, the staff considered that there is new information from the respondents that the Board had not considered when developing the amendments. This includes the conditions designed to incorporate the effects of seasonality, business growth or restructuring and the information provided by a binary classification of liabilities as current or non-current. This information might be insufficient to allow an understanding of an entity's financial position when the right to defer settlement is subject to compliance with specified conditions after the reporting period. Therefore, the staff considered it worth to report these to the Board.

Staff recommendation

Based on the analysis, the staff recommended reporting to the Board the Committee's technical analysis and conclusions on the matter and respondents’ comments on the outcomes, highlighting those that might provide new information to the Board. The staff asked whether the Committee agrees with reporting the proposed matters to the Board and whether the Committee wishes to finalise the agenda decision.

Discussion

Committee members agreed with the conclusion set out in the tentative agenda decision and considered that the application of the principle of "unconditional right" in the amendments to IAS 1 has been clearly demonstrated in the three cases. However, given the overwhelming concerns on the outcome of the application of the amendments, they suggested reporting the matter to the Board, emphasising the new information obtained from the respondents.

Many of the Committee members commented that the outcome of classifying liabilities as current liabilities by applying the amendments may fail to present the facts faithfully because it may be inconsistent with the purpose and the economic substance of the covenant. Particularly, the financial position of many businesses in certain jurisdictions is actually highly affected by the seasonality. If it is not considered, the impact would be tremendous because the classification of one liability may trigger the classification of other liabilities as current. Moreover, the application of the amendments may result in volatility in the financial position of an entity which is harmful to the entity and not useful to decision makers.

Some of the Committee members pointed out that it is unclear as to why IAS 1:BC48E is applicable to financial performance only and not to non-performance or non-financial conditions. They were not convinced that IAS 1:BC48E could not be applied to financial position ratios because performance and financial position are correlated. It is inconsistent that it is applicable to financial performance only. Also, they struggled to agree that management judgement could not be applied to the expectation that covenants related to financial position should be tested within 12 months from the reporting period when more information is available.

Therefore, most of the Committee members, except one, voted for not finalising the agenda decision at this stage but to defer the matter to the Board, particularly highlighting the new information raised by respondents to the tentative agenda decision that the Board may not have specifically considered when developing the amendments. The member who agreed with finalising the agenda decision agreed that the matter should be reported to the Board, but at the same time the agenda decision could be finalised because it clearly illustrated the principles of the amendments to IAS 1.

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