Liquidity risk – give us the worst case!

A European example of issues arising in classifying liabilities for purposes of liquidity disclosures

Here’s another of the issues arising from extracts of enforcement decisions issued in the past by the European Securities and Markets Authority (ESMA); this is from their 24th edition:

  • The issuer issued loan notes (i.e. financial liabilities) that all have a contractual maturity date of 2040. Both the issuer and the noteholders have an option to early redeem the notes before the maturity date. The issuer has the option to call the loan notes by giving an irrevocable notice to the noteholders, subject to a 5-day notice period. The noteholders have a put option to early redeem the loan notes before the maturity date, subject to a 10-day notice period. However, all noteholders have signed a waiver that waives their right to exercise the option to early redeem for at least 12 months from the year-end date.
  • Furthermore, every two weeks the noteholders can subscribe for or request the redemption of loan notes (in addition to the abovementioned put option) through a “bi-weekly liquidity process”. The issuer makes the final decision on whether or not to execute these redemption requests. The issuer confirmed that it has not denied any redemptions requests during the year.
  • In the liquidity maturity analysis table prepared in accordance with paragraph 39(a) of IFRS 7, the issuer classified these loan notes as having a maturity ‘greater than five years’. However, in recent years, material redemptions and repurchases of notes have occurred. The issuer noted that all of these redemptions are part of the normal course of business for the issuer and are driven by the liquidity needs of the noteholders and were not due to exercising the ‘put option’ by any of the noteholders.
  • The issuer argued that, as the redeemed loan notes can be re-purchased by another party with the same contractual maturity date (i.e. the issuer can re-issue the loan notes), there is no direct link between the contractual maturity date of the loan notes and the noteholder. With regards to the redemptions and repurchases that occurred, the issuer also argued that, as there is no party who can contractually require the issuer to redeem the loan notes since the redemptions can only occur by mutual consent, the liability is thus required to be classified in the time range when the entity can be required to pay. Accordingly, the issuer argued that the ‘greater than five years’ liquidity table time range correctly reflects the earliest contractual maturity date.

The enforcer (as ESMA likes to term it) disagreed, requiring that the issuer present the loan notes as maturing in the ‘greater than one-year’ time range. It noted that in its guidance on preparing this disclosure, IFRS 7 indicates that when a counterparty has a choice of when an amount is paid, the liability is allocated to the earliest period in which the entity can be required to pay. The standard’s basis for conclusions specifies that this was designed to show a “worst case scenario” – if that differs from what’s expected in normal circumstances, then that can be addressed in the accompanying disclosure about how the entity manages the liquidity risk portrayed in the analysis. The enforcer accepted that the instruments needn’t be shown as having a maturity of less than one year, given that the requests under the bi-weekly redemption process aren’t contractually binding, and that the broader early redemption option has been waived for twelve months. However, there’s nothing in place that prevents them from being redeemed sooner than five years. On this point, the last paragraph quoted above isn’t very coherent, and doesn’t seem to engage at all with the put option (hopefully it made more sense as articulated by the issuer, albeit that it didn’t provide enough to win the argument).

This example is somewhat related to issues that sometimes come up in determining the classification of financial liabilities on the balance sheet – for example the IAS 1 requirement that a long-term loan arrangement that’s become payable on demand because of a covenant breach is classified as current, even if the lender has subsequently agreed not to demand repayment for over a year. For smaller companies, a common comparable example relates to related party financing which is technically repayable on demand at the end of the reporting period and therefore shown as current, no matter what everyone involved knows and intends. In such cases, while the current classification may make sense in conceptual terms, it may arguably result in a balance sheet that’s less immediately useful for predictive purposes than a presentation reflecting subsequent events and waivers would be. But as always, the numbers only provide a snapshot, and can’t speak in themselves (as the notes and the MD&A can) to the complexities of what lies beyond the edges of the frame…

The opinions expressed are solely those of the author

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