Classification of liabilities as current or non-current
Key takeaways
- Right to defer settlement must have substance and exist at reporting date
- Only covenants that must be complied with on or before reporting date affect classification of liabilities arising from loan arrangements
- New disclosures introduced for non-current loans subject to compliance with covenants post balance date
- The amendments clarify how a counterparty conversion option affects classification of the host debt
- Effective date of the changes is 1 January 2024
Background
AASB 101 Presentation of Financial Statements is the accounting standard that sets out the requirements to consider when classifying liabilities as current or non-current.
There have been changes to the paragraphs dealing with the classification of liabilities, first in early 2020 and more recently at the end of 2022. However, the amendments do not change the existing requirements but rather clarify them. This is to align accounting practice in an area that has been subject to differing interpretations, resulting in similar liabilities being classified differently by entities and undermining comparability of financial information.
The amendments
Rights must exist at reporting date
Currently, AASB 101 requires a liability to be classified as current when an entity does not have an unconditional right to defer settlement thereof for at least 12 months after reporting date. The changes remove the word ‘unconditional’ and instead require that a right to defer settlement must exist at the reporting date and must have substance.
Furthermore, it is now explicitly stated in paragraph 75A that classification of a liability is unaffected by management’s intentions or expectations about whether the entity will exercise its right to defer settlement or choose to settle early.
Any expectations about events after reporting date but prior to the date the financial statements are signed do not impact the classification assessment as at reporting date. Therefore, although management may have an intention to settle a liability shortly after the end of the reporting period, if it has a right to defer settlement for at least 12 months as at that date, the liability is classified as non-current. However, disclosures may be appropriate to enable users to understand the impact of the liability on the entity’s financial position.
Example 1
Entity A has a loan facility that expires on 30 June 2024, with the substantive right to roll over the facility for an additional 12 months as at 30 June 2023 (year end). At this date, Entity A has the intention to settle the loan on 27 August 2023, which is before the financial statements for 30 June 2023 are signed on 15 September 2023.
Applying the new guidance, the loan would be classified as non-current at 30 June 2023 since Entity A has the right to defer settlement for at least 12 months from that date. That is, Entity A’s intention to repay the loan on 27 August 2023 does not affect classification at reporting date. Repayment of the loan before the financial statements are signed may, however, require disclosure as a subsequent event depending on how material the loan is.
Loans subject to covenants
An entity’s right to defer settlement of a loan often depends on compliance with specified conditions. For example, a long-term loan could become repayable within 12 months from reporting date if the entity fails to comply with stipulated loan covenants in that 12- month period.
The most recent amendments clarify that only covenants that must be complied with on or before the reporting date affect classification of loans at that date. However, where noncurrent loans are subject to compliance with covenants after the reporting date, information that enables users of financial statements to understand the risk of those loans becoming repayable within 12 months after the reporting period must be disclosed in the notes. These disclosure requirements are new and include:
- Information about the covenants and the carrying amount of related liabilities;
- Facts and circumstances, if any, that indicate the entity may have difficulty complying with the covenants.
Example 2A
Entity P has a bank borrowing for a period of five years. The borrowing facility provides for a covenant that requires a current ratio above 1.2 as at 30 June each year. The borrowing will become repayable on demand if the covenant is breached.
Entity P’s current ratio is as follows:
- 31 December 20X3 1.15
- 30 June 20X4 (expected) 1.25
How will Entity P classify the related borrowing at year end, being 31 December 20X3?
Entity P is required to comply with the covenant after the end of the reporting period. Therefore, the covenant does not affect whether the right to defer settlement for at least 12 months after the reporting period exists at the end of the reporting period.
Assuming the covenant was met on 30 June 20X3, Entity P classifies the loan as non-current as at 31 December 20X3.
As required by AASB 101.76ZA, Entity P will be required to disclose information that enables users to understand the risk that the borrowing could become repayable within 12 months after reporting date.
Example 2B
Entity P has a bank borrowing for a period of five years. The borrowing facility provides for a covenant that requires a current ratio above 1.2 as at 30 June each year. The borrowing will become repayable on demand if the covenant is breached.
Entity P’s current ratio is as follows:
- 30 June 20X3 1.25
- 31 December 20X3 1.15
- 30 June 20X4 (expected) 1.05
How will Entity P classify the related borrowing at year end, being 31 December 20X3?
In this case, Entity P has met the covenant on 30 June 20X3 and therefore the loan is not repayable on demand at 31 December 20X3.
Entity B is required to meet the covenant next on 30 June 20X4 which is after the end of the reporting period. As such, this covenant does not affect whether the right to defer settlement exists at the end of the reporting period and the borrowing will be classified as non-current on 31 December 20X3.
The expectation that the covenant will not be met at the next date of compliance testing i.e. 30 June 20X4, which is subsequent to the reporting period, does not have an effect on the determination of the classification of the liability at year end. However, Entity P will need to disclose facts and circumstances in its 31 December 20X3 financial statements that indicate it may have difficulty complying with the covenant, as required by AASB 101.76ZA.
Example 2C
Entity X has a loan for a period of seven years. The loan facility provides for a covenant that requires a working capital ratio above 1 as at 30 June each year. The loan will become repayable on demand if the covenant is not met.
Entity X’s working capital ratio is as follows:
- 30 June 20X3 0.85
- 31 December 20X3 0.90
- 30 June 20X4 (expected) 1.05
How will Entity X classify the related borrowing at year end, being 31 December 20X3?
As the covenant is not met on 30 June 20X3, the loan is currently payable on demand (i.e. at 31 December 20X3). Entity X does not have the right to defer settlement for at least 12 months therefore the loan will be classified as current at 31 December 20X3.
The expectation that the working capital ratio will be met on 30 June 20X4 (the next testing date) does not affect the classification of the loan as at 31 December 20X3.
‘Settlement’ of a liability
Guidance has been added to clarify what is meant by ‘settlement’ of a liability via the inclusion of two new paragraphs (paragraphs 76A and 76B).
Paragraph 76A links settlement of a liability with the outflow of resources of the entity, which could take the form of cash, other economic resources, or the entity’s own equity instruments.
The addition of paragraph 76B clarifies how an entity classifies a liability that includes a counterparty conversion option, which could be recognised as either equity or a liability separately from the host debt component in accordance with AASB 132 Financial Instruments: Presentation. It has now been clarified that when classifying liabilities as current or non-current, only those conversion options that are recognised as equity can be disregarded.
Example 3
Entity B issues a $500,000 convertible note, exercisable at the option of the holder at any time prior to redemption date. There is no interest on the note and the note is repayable in four years’ time unless the holder converts before then, in which case the note coverts into 500,000 shares of Entity B (i.e. fixed number of shares).
The convertible note gives rise to a compound financial instrument with a financial liability component (the note payable) and an equity component (the conversion feature). Applying the new guidance in paragraph 76B, the conversion feature (which can be exercised at any time by the holder prior to redemption) does not affect the note’s classification because the conversion feature is an equity instrument. This means the host liability would be classified as non-current as the principal is not due for four years, meaning Entity B has the right to defer settlement for at least 12 months. A similar assessment would not be required for the conversion feature since equity is not classified as current or non-current.
Example 4
Assume the same facts as Example 2 except conversion of the note results in a variable number of shares being issued due to the exercise price being in USD.
In this case, the convertible note would give rise to a financial liability component (the note payable) and a derivative financial liability (the conversion feature). Applying the new guidance in paragraph 76B, the conversion feature (which can be exercised at any time by the holder prior to redemption) does affect the note’s classification because the conversion feature is not an equity instrument. The host debt (note payable) would therefore be classified as a current liability because the option can be exercised at any time by the holder, meaning Entity B does not have the right to defer settlement of the liability for at least 12 months. The derivative financial liability would also be classified as current for the same reason.
Effective date
The 2020 and 2022 amendments apply retrospectively for annual reporting periods beginning on or after 1 January 2024. Therefore, for December year ends, these amendments are now live. For June year ends, the amendments will apply for the first time in 30 June 2025 financial statements, unless adopted earlier.
Important: The information contained in this post / article is not advice. Readers should not act solely on the basis of material contained in this post. Items herein are general comments only and do not constitute or convey advice per se. We recommend that our formal advice be sought before acting on anything contained in this post.
