Changes to IAS 1 - Classification of borrowings as current vs. non-current may change for some entities

On 23 January 2020, the International Accounting Standards Board issued narrow-scope amendments to IAS 1 Presentation of Financial Statements which clarify how to classify liabilities as current or non-current.

The amendments are intended to merely clarify the existing requirements contained in IAS 1, paragraphs 69 to 76. However, diversity in practice has emerged in a number of areas due to perceived inconsistencies in IAS 1 where certain paragraphs appear to contradict one another. We therefore expect to see significant changes in how some entities classify their liabilities.

It is important to note that the classification requirements in IAS 1, paragraph 69 relate to all liabilities (such as employee benefit liabilities, provisions, tax liabilities, lease liabilities, contract liabilities, etc.) and not merely to financial liabilities under IFRS 9 Financial Instruments.

Effective date

The amendments are effective for annual reporting periods beginning on or after 1 January 2022 and apply retrospectively (i.e. comparatives need to be restated). The amendments can be adopted early once approved as a New Zealand standard by the New Zealand Accounting Standards Board.

What’s changed?

The table below shows the existing and new terminology contained in IAS 1, which describes the requirements for classification of long-term liabilities, and some of the related guidance paragraphs.

Note: Not all guidance paragraphs have been included below, only those with substantive changes are set out below.  

Paragraph reference	Existing terminology	New terminology
69(d)	It does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period (see paragraph 73).	It 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.
73	If an entity expects, and has the discretion to refinance or roll over an obligation for at least twelve months after the reporting under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period. However, when refinancing or rolling over the obligation is not at the discretion of the entity (for example, there is no arrangement for refinancing), the entity does not consider the potential to refinance the obligation and classifies the obligation as current.	If an entity has the right, at the end of the reporting period, to roll over an obligation for at least twelve months after the reporting under an existing loan facility, it classifies the obligation as non-current, even if it would otherwise be due within a shorter period. If it has no such right, the entity does not consider the potential to refinance the obligation and classifies the obligation as current.
New		New paragraph 76A For the purpose of classifying a liability as current or non-current, settlement refers to a transfer to the counterparty that results in the extinguishment of the liability. The transfer could be of: Cash or other economic resources – for example, goods or services, or The entity’s own equity instruments, unless paragraph 76B applies.
New	Old paragraph 69(d) 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.	New paragraph 76B 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, recognising it separately from the liability as an equity component of a compound financial instrument.

 

The main changes to these classification requirements include the following:

• The requirement for an ‘unconditional’ right has been deleted from paragraph 69(d)
• The right to defer settlement must exist at the end of the reporting period
• Classification is based on the right to defer settlement, and not intention (paragraph 73), and
• If a liability could be settled by an entity transferring its own equity instruments prior to maturity (e.g. a convertible bond), classification is determined without considering the possibility of earlier settlement by conversion to equity, but only if the conversion feature is classified as equity under IAS 32 Financial Instruments: Presentation.

The implications of these changes is discussed further below.

Rights - not unconditional rights (covenants)

The reference to ‘unconditional rights’ has been removed from paragraph 69(d) because rights to defer settlement are rarely unconditional (i.e. they are often conditional upon compliance with covenants).

New guidance has been added in paragraph 72A to clarify that if a 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.

Example 1

Entity A has a 31 December 20X2 year-end.

Entity A has a long-term bank loan that will be repayable in five years, however, the bank has the right to demand repayment immediately if Entity A does not maintain a specified debt to equity ratio as at each year-end.

The contractual terms of the bank loan stipulate that compliance with this covenant will be assessed based on the audited financial statements that Entity A’s management must provide to the bank by 31 March of the following calendar year.

Analysis

In order for the bank loan to be classified as a NON-CURRENT LIABILITY at 31 December 20X2, Entity A must comply with the conditions of the bank covenants (debt to equity ratio) at the end of the reporting period (31 December 20X2).

This requirement exists regardless of the fact that compliance with the covenant will not be tested until 31 March 20X3, which is after the financial statements are authorised for issue because the covenant is tested based on audited financial statements.

Therefore, Entity A calculates its debt to equity ratio, and classifies the bank loan as a current or non-current liability in its 31 December 20X2 financial statements based on the outcome of this calculation.
 

Debt to equity ratio	Balance sheet liability classification
Meets requirements of covenant at reporting date	NON-CURRENT LIABILITY
Fails to meet requirements of covenant at reporting date	CURRENT LIABILITY

 

Right to defer settlement – not intention

The amendments to paragraph 73 result in classification which is based on the right to defer settlement, and not intention. In future, we could therefore expect to see changes in the way some entities are classifying liabilities.

Fact pattern	Existing terminology	New terminology
Entity B has a loan facility with Bank B which expires 31 March 2023. Assume Entity B has the right to roll over the loan for a further 12 months at 31 December 2022 (i.e. rollover approved by Bank B prior to 31 December 2022). At 31 December 2022, Entity B intends to repay the loan to Bank B on 31 March 2023. The 31 December 2022 financial statements are authorised for issue on 30 April 2023.	Loan is classified as CURRENT Under the existing version of IAS 1, the loan would be classified as a CURRENT LIABILITY because Entity B did not expect to roll over the loan.	Loan is classified as NON-CURRENT Under the new version, the loan would be classified as a NON-CURRENT LIABILITY because, irrespective of Entity B’s intention to repay the loan, Entity B has a right to defer settlement for more than 12 months after reporting date.

Under the new classification rules, Entity B classifies the bank loan as NON-CURRENT, even if it settles the loan in full on 31 March 2023, which is before the financial statements are authorised for issue. This is because the revised wording only looks at the right to defer settlement, and not intention. However, Entity B 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.

 

Settlement of liability by transfer of entity’s own equity instruments

The old wording in paragraph 69(a) notes that a liability arising from a bond convertible into equity of the issuer prior to maturity is classified as current or non-current according to the terms of the bond, without considering the possibility of earlier settlement by the conversion to equity.

New guidance paragraph 76B clarifies that this exception only applies to bonds where the conversion feature is classified as an EQUITY INSTRUMENT under IAS 32.

When classifying convertible bonds or notes with conversion features classified as LIABILITY or a DERIVATIVE LIABILITY, entities cannot ignore early conversion options.

In future, we could see convertible notes being classified differently in the financial statements depending on whether the conversion feature fails the ‘fixed for fixed’ criterion for equity classification (refer Examples 2 and 3 below).

Example 2 – Convertible debt with conversion feature classified as EQUITY

Entity C issues a $1 million note payable with an ‘American style’ conversion option, exercisable at the option of the holder at any time over the life of the note.

Once exercised, the conversion feature will convert the note into 1 million ordinary shares of Entity C, otherwise, the note payable is repayable, plus interest, in five years.

The note is quoted in NZD which is the functional currency of Entity C.

Analysis

The debt (repayable portion) of the note is classified as a financial liability.

The conversion feature is classified as an EQUITY INSTRUMENT under IAS 32 (therefore the note is a compound financial instrument) because it meets the ‘fixed for fixed’ test (i.e. at initial recognition, the note is convertible into a fixed number of ordinary shares - 1 million shares).

The components of the compound financial instrument are classified as follows:

Component	Classification	Rationale
Financial liability – note payable	Non-current liability	Applying IAS 1, paragraph 76B, the conversion feature, which may be exercised by the holder at any time, does not affect the note’s classification as current or non-current because the conversion feature is classified as an equity instrument. The principal and accrued interest are not due for five years, therefore, Entity C has the right to defer settlement for at least twelve months (IAS 1.69(d)).
Equity component – conversion feature	N/A – equity	Equity is not classified as current or non-current.

Example 3 – Convertible debt with conversion feature classified as DERIVATIVE FINANCIAL LIABILITY

Same facts as Example 2 above, except that the note is quoted in AUD  which is not the functional currency of Entity C (i.e. NZD).

Analysis

The debt (repayable portion) of the note is classified as a financial liability.

Because the note is denominated in a currency other than the functional currency of Entity C, the conversion feature is classified as a DERIVATIVE FINANCIAL LIABILITY. The amount of cash that will be required to settle the liability on conversion is not represented by a fixed amount expressed in Entity C’s functional currency.

The components of the compound financial instrument are classified as follows:

Component	Classification	Rationale
Financial liability – note payable	Current liability	Applying IAS 1, paragraph 76B, the conversion feature, which may be exercised by the holder at any time, does affect the note’s classification as current or non-current because the conversion feature is not classified as an equity instrument. As the option may be exercised at any time, the entity does not have the right to defer settlement of the liability for at least twelve months (IAS 1.69(d)).
Derivative financial liability – conversion feature	Current liability	The conversion feature may be exercised by the holder at any time, and therefore, Entity C does not have the right to defer its settlement for at least twelve months (IAS 1.69(d)).

 

We can see from the above examples that the current / non-current classification is affected by how the conversion feature is classified.

In Example 2, the host financial liability (the note payable) is classified as NON-CURRENT, and the conversion feature is not classified because it is an equity instrument.

In Example 3, an extremely similar instrument has both of its components classified as financial liabilities and they are both classified as CURRENT LIABILITIES.  

The introduction of the new paragraphs 76A and 76B may therefore have a significant impact on entities that issue convertible notes.

No changes to paragraphs 69(a) to (c)

There have been no changes to paragraphs 69(a) to (c). This means that liabilities that meet at least one of the following criteria are classified as CURRENT LIABILITIES, otherwise they are classified as NON-CURRENT:

• If the entity expects to settle the liability within its normal operating cycle (e.g. trade payables)
• If the entity holds the liability primarily for the purpose of trading, or
• If the liability is due to be settled within 12 months after the reporting period.
   

Conclusion

As noted above, the amendments to IAS 1 are effective for annual reporting periods beginning on or after 1 January 2022, with retrospective restatement required. Therefore, in an entity’s 31 December 2022 financial statements, the effects of these amendments must be reflected in the 31 December 2021 comparative period.

We strongly encourage entities to assess the impact of the amendments as soon as possible to ensure the effects are understood. In some cases, entities may wish to amend certain agreements, covenants and arrangements if the amendments could result in an undesirable outcome, such as a violation of a covenant due to certain liabilities being reclassified as current.  
 

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Please refer to BDO’s International Financial Reporting Bulletin for more information on these changes to IAS 1 or contact your local BDO representative.