Classification of liabilities – suppress your creativity!

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 25th edition:

  • The issuer is a biotechnology company. In October 2017, the issuer issued debt fully subscribed by company B, for an amount representing around 30% of the total liabilities of the issuer. According to the initial terms of the loan, the repayment was due in October 2020. Concurrently, the issuer signed another contract with company B with similar maturity, to develop activities in the area of biotechnology. The issuer considered the two contracts linked as the loan was used to finance the activities and operations foreseen in the second contract.
  • In the end of 2019, the issuer requested the extension of the term of both contracts (the loan and the development contract) by one year. While the development contract was extended without further ado, in December 2019, company B signed a letter notifying the issuer that the extension of the debt maturity to October 2021 was upon condition that the issuer formally demonstrated its ability to reimburse the loan at the new maturity date. As of December 31, 2019, company B had not formally validated that the condition set in the letter was met.
  • In April 2020, an amendment to the debt agreement was signed between the issuer and company B deferring the repayment of the debt liability to October 2021.
  • In its financial statements as of December 31, 2019, the issuer classified the financial liability as a non-current liability. The issuer considered that the condition set by the letter signed by company B in December 2019 was met at the closing date because: a) in December 2019, the issuer signed a preliminary financing term agreement with company C (a new investor) for an amount that the issuer considered sufficient to finance its current operations for two years and the reimbursement of the debt with company B by October 2021; b) company B, who was represented on the issuer’s board of directors, was informed of the financial situation, the liquidity, the financial projections of the issuer and the new financing term signed with company C.

The enforcer (as ESMA likes to term it) disagreed with this analysis, on the basis that “as of December 30, 2019, the issuer did not have the unconditional right to defer the repayment of the liability for at least twelve months after the reporting date. The enforcer noted that, as of December 31, 2019, there was no legal and formal amendment of the debt agreement, or a formal and legally binding acknowledgement of company B that the conditions for extension of the debt maturity were met. Therefore, the enforcer required the issuer to reclassify the debt as current.

The conclusion seems inevitable, when focusing on that core concept of having an unconditional right as of the end of the reporting period, regardless of management’s expectations. As we’ve noted before, preparers continue to be drawn occasionally to the premise that such expectations should sometimes matter – for example, if a long-term debt is classified as current at the end of the reporting period only because of a covenant breach, and the issuer obtains a waiver before the statements are authorized for issue, it might be appealing to argue that long-term classification provides the most meaningful predictive value in the light of subsequent negotiations. A dwindling bunch of us recall that old Canadian GAAP did allow taking exactly this backward-looking approach, and so did IAS 1 when it first appeared in 1997 – the present approach dates back to an exposure draft from 2002. Some comment letters back then disagreed: “They advocated classifying a liability as current or non-current according to whether it is expected to use current assets of the entity, rather than strictly on the basis of its date of maturity and whether it is callable at the end of the reporting period. In their view, this would provide more relevant information about the liability’s future effect on the timing of the entity’s resource flows.” But the IASB was persuaded instead to focus more sharply on rights and obligations as they exist at the end of the reporting period, and that’s where things remain.

Even with all that, it’s possible to have some sympathy for the issuer in the case above. We’re not told in the fact pattern whether or not the financial statements were issued subsequently to the formal extension in April 2020, but if we assume for the sake of argument that they were, it would have added to the issuer’s underlying argument, that there was no likelihood of non-current classification as at the end of December 2019 subsequently being undone, and no chance of financial statements prepared on that basis proving to be misleading regarding liquidity needs. But regardless, the issuer got it wrong…

The opinions expressed are solely those of the author

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