Non-current liabilities with covenants – leave the future out of it!

As we covered here, the IASB has issued for comment Non-current Liabilities with Covenants, an exposure draft of proposed amendments to IAS 1, with comments to be received by March 21, 2022.

The proposals would amend the current guidance on determining whether an entity has a right to defer settlement of a liability for at least twelve months. We previously looked at some of the reaction to one of the IASB’s presentation proposals. The proposals also contain the following proposed guidance:

  • An entity does not have the right to defer settlement of a liability for at least twelve months…if the liability could become repayable within twelve months after the reporting period:
    • at the discretion of the counterparty or a third party—for example, when a loan is callable by the lender at any time without cause; or
    • if an uncertain future event or outcome occurs (or does not occur) and its occurrence (or non-occurrence) is unaffected by the entity’s future actions—for example, when the liability is a financial guarantee or insurance contract liability.

Some respondents, such as EY, disagreed with that second aspect:

  • We do not support the proposal to introduce an entity’s ability to impact the occurrence or non-occurrence of uncertain future events or outcomes as a determinative factor when assessing whether a liability should be classified as current or non-current, since the underlying concept or principle aligning a “right” with the notion of “unaffected” is unclear. Furthermore, the notion of “unaffected” is not defined, and it would be difficult to define, therefore, it will be challenging to apply in practice. We believe a more consistent approach, both conceptually and practically, would be to remove (this paragraph). This would allow for the assessment of whether a right exists at the end of the reporting period, based on the conditions at the reporting date, regardless of an entity’s ability to affect the occurrence or non-occurrence of that uncertain future event or outcome.

Some respondents suggested that a few lines of commentary currently placed in the basis for conclusions (clarifying for instance that a liability which might become repayable within twelve months only if the entity fails to meet a future revenue target wouldn’t be classified as current) should be placed in the body of the standard itself. Other respondents felt more to be necessary. The Japanese Institute of Certified Public Accountants provided various examples to illustrate situations where the application might not be clear:

  • Change-in-control provision When an entity issues preferred stocks with a mandatory redemption provision in five years, which are subject to conditions under which holders of the preferred stocks are entitled to demand early redemption whenever there are changes in control of the entity, and when its occurrence is unaffected by the entity’s future actions.
  • Initial public offering (IPO) within twelve months When an entity issues preferred stocks with a mandatory redemption provision in five years, which are subject to conditions under which holders of the preferred stocks are entitled to demand early redemption whenever the entity cannot execute IPO within twelve months, and when its occurrence is unaffected by the entity’s future actions.
  • A contract requiring an entity to obtain an unqualified opinion from auditors within three months from a reporting period When an entity, as the borrower, has a loan with maturity in five years, which is subject to conditions under which the lender is entitled to demand early redemption if the entity cannot obtain an unqualified opinion from auditors within three months from a reporting period.

This is from the Malaysian Accounting Standards Board:

  • The meaning of “unaffected by the entity’s future actions” is not clear in the context of liabilities generally. The examples provided…[financial guarantees and insurance contracts] presumably relate to a counterparty’s creditworthiness and a policyholder having a valid insurance claim – both of which are beyond the entity’s control.
  • However, in the context of a borrowing, it is unclear what types of factors would be identified as being beyond the entity’s control. For example, there might be cases when an entity’s profitability, revenues, or interest expense are among the factors affecting conditions attaching to the continuation of a loan. It seems equally plausible, depending on the circumstances, to consider that these factors would be unaffected by the entity’s future actions; or, alternatively, that they could be affected by the entity’s future actions.

As we’ve covered before, preparers often have an intuitive objection to the notion that the assessment of current or non-current classification should be based solely on rights (for instance, in cases where, regardless of the lender’s right to demand repayment within twelve months, there’s almost no practical likelihood of it doing so). Still, at least that requirement is susceptible to being fairly easily explained on the basis of present facts and circumstances. If entities were required to prepare two or more balance sheets, then it might be plausible to present contrasting snapshots based on different outcomes for those uncertain future events. But under the current model, perhaps EY is right that this should be left as another reason to carefully read the notes…

The opinions expressed are solely those of the author

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