Classification of liabilities, or: the rights stuff

The IASB has issued Classification of Liabilities as Current or Non-Current, amendments to IAS 1.

The amendments are to be applied retrospectively for annual reporting periods beginning on or after January 1, 2022 – earlier application is permitted. The extended application date responds to the possibility that changes in classification as a result of the amendments might affect a company’s loan covenants, and thus require additional preparation time. Overall though, “the amendments clarify, not change, existing requirements, and so are not expected to affect companies’ financial statements significantly.”

IAS 1.69 currently sets out four different circumstances in which an entity classifies a liability as current. The fourth of these arises when the entity “does not have an unconditional right at the end of the reporting period to defer settlement of the liability for at least twelve months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification.” Following the amendment, this will refer instead to a situation where the entity “does not have the right at the end of the reporting period to defer settlement of the liability for at least twelve months after the reporting period.”

To deal first with the front part of that, why refer now only to a “right…to defer” rather than to the previous “unconditional right”? In part, it reflects a perceived inconsistency between the concept of the unconditional right, and the following passage:

  • If an entity expects, and has the discretion, to refinance or roll over an obligation for at least twelve months after the reporting period under an existing loan facility, it classifies the obligation as non‑current, even if it would otherwise be due within a shorter period.

That is, the references to expectation and discretion may suggest a zone of judgment in a way that “unconditional right” doesn’t. The amendments remove all those references, referring simply to rights, and adding the following explanations:

  • An entity’s right to defer settlement of a liability for at least twelve months after the reporting period must have substance and…must exist at the end of the reporting period. If the right to defer settlement is subject to the entity complying with specified conditions, the right exists at the end of the reporting period only if the entity complies with those conditions at the end of the reporting period. The entity must comply with the conditions at the end of the reporting period even if the lender does not test compliance until a later date….
  • 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. If a liability meets the criteria…for classification as non-current, it is classified as non-current even if management intends or expects the entity to settle the liability within twelve months after the reporting period, or even if the entity settles the liability between the end of the reporting period and the date the financial statements are authorized for issue. However, in either of those circumstances, the entity may need to disclose information about the timing of settlement to enable users of its financial statements to understand the impact of the liability on the entity’s financial position

The excised portion of the current definition – about terms that could, at the option of the counterparty, result in its settlement by the issue of equity instruments – is now addressed further along in IAS 1, in slightly different form:

  • Terms of a liability that could, at the option of the counterparty, result in its settlement by the transfer of the entity’s own equity instruments do not affect its classification as current or non-current if, applying IAS 32 Financial Instruments: Presentation, the entity classifies the option as an equity instrument, recognizing it separately from the liability as an equity component of a compound financial instrument.

The point being, for example, that a bond that the holder may convert to equity before maturity is classified as current or noncurrent according to the terms of the bond, without considering the possibility of earlier settlement by conversion to equity. But if the conversion feature is classified as a liability because, say, of variable conversion terms, then the option to deliver shares would be taken into account in assessing the settlement terms, and in turn the classification as current or non-current.

This project has been around for a while – comments on the originating exposure draft were due by June 10, 2015. In 2016 work was delayed until after the Board had redeliberated the definitions of assets and liabilities in the Conceptual Framework exposure draft, starting up again in late 2018. So since then you might say it’s moved pretty quickly!

The opinions expressed are solely those of the author

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