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What companies need to consider for classification of liabilities

IAS 1 amendments to classification of liabilities with covenants as current or non-current are effective from 1 January 2024.

In brief

  • The amendments to IAS 1 may lead to changes in the classification of certain liabilities as current or non-current. 
  • The amendments clarify that the right to defer settlement of a liability must exist for at least 12 months after the reporting period.
  • Companies may need to provide additional disclosures for liabilities classified as non-current and subject to covenants within 12 months of the reporting date. 

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The classification of liabilities with covenants as current or non-current could significantly affect a company’s presentation of its financial position and, hence, the company’s financial metrics. In response, the International Accounting Standards Board issued amendments to IAS 1 Presentation to Financial Statements in 2020 and 2022, with the objective of improving the information a company provides about liabilities with covenants, in addition to addressing stakeholders’ concerns about how a company classifies liabilities with covenants as current or non-current. The amendments will become effective for annual reporting periods beginning on or after 1 January 2024 with early application permitted.

 

Requirements on classification of liabilities with covenants

 

According to the existing requirements for classifying a liability as current or non-current, a liability is current if, among others, the company does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.

 

With the introduction of the two amendments to IAS 1 in 2024, for a liability to be classified as non-current, a company must have the right to defer settlement of the liability for at least twelve months after the reporting period. The right must have substance and exist at the end of the reporting period and the classification of the liability must be unaffected by the likelihood that the company will exercise that right. If a company is required to comply with covenants on or before the end of the reporting period, these covenants will affect whether such a right exists at the end of the reporting period. 

Covenants that a company is required to comply with on or before the end of the reporting period will affect whether the right to defer settlement exists at the end of the reporting period.

This is the case even if compliance with the covenant is assessed only after the reporting period. One example is a covenant based on the company’s financial position at the end of the reporting period, but the assessment for compliance is performed only after the reporting period.

A company that has a right to defer settlement at the end of the reporting period is not affected by a covenant if it is required to comply with the covenant only after the end of the reporting period.

The amendments go on to explain that a covenant does not affect whether the right to defer settlement exists at the end of the reporting period if a company is required to comply with the covenant only after the end of the reporting period. This will be the case, when, for example, a covenant is based on the company’s financial position six months after the end of the reporting period. 

Additional disclosure requirements

There are additional disclosure requirements if a company classifies liabilities arising from loan arrangements as non-current while its right to defer settlement of those liabilities is subject to its compliance with covenants within twelve months after the reporting date. In such a case, the company needs to disclose information in the notes to the financial statements so that users understand the risk that the liabilities could become repayable within twelve months after the reporting date. The disclosure requirements include providing information about the covenants, such as the nature of the covenants, when the company is required to comply with them and the carrying amount of related liabilities. Companies are also required to disclose facts and circumstances, if any, that indicate they may have difficulty complying with the covenants, such as any action the company has taken during or after the reporting period to avoid or mitigate a potential breach.

If a company expects that it may have difficulty complying with the covenants, the company must disclose this, such as any action it has taken during or after the reporting period to avoid or mitigate a potential breach.

Such facts and circumstances could also include the fact that the company would not have complied with the covenants if it were to be assessed for compliance based on its circumstances at the end of the reporting period.

Classification of liabilities when there is a breach in covenant

The existing requirements for the liability classification when there is a breach in covenant remain unchanged. When a company breaches a covenant of a long-term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current. Companies often negotiate with the lender not to demand payment as a consequence of the breach. To classify the liability as non-current at the end of the reporting period, such a waiver needs to be obtained by the reporting date so that the liability is not payable within twelve months from the end of the reporting period. If such a waiver is only obtained after the reporting date, but before the authorization of the financial statements, the liability is still presented as current.

Conclusion and action steps

Executives and board members will need to carefully consider the impact of the amendments on the presentation and disclosure of the company’s financial statements going forward. In light of the prevailing economic environment with high interest rates and stagnant growth, companies’ financial performance may deteriorate and, thus, they may need to renegotiate covenant terms with lenders in a timely manner to avoid potential breaches which may affect the classification of the related liabilities once these amendments become effective in 2024.

Summary

The amendments to IAS 1, effective on 1 January 2024, clarify the criteria for classifying liabilities with covenants as current or non-current. The amendments will also require companies to provide additional information to stakeholders. The changes introduced by the amendments require companies to consider the potential impact for their loan arrangements and the presentation of their financial statements.

About this article

Victor Chan

International Director, Global IFRS Services, Ernst & Young Global Limited

Develops insights on applying IFRS to emerging accounting issues. Focuses on leases, crypto-assets, investment property and latest standard-setting activities. Enjoys relaxing with family.

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