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There have recently been some major breaches of debt covenants reported by companies, but the issue then arises as to how this liability is reported. The question is whether the liability is a current or non-current liability and how to present the liability in the statement of financial position.
IAS 1, Presentation of Financial Statements, paragraph 60 stipulates that an entity should present current and non-current liabilities as separate classifications in its statement of financial position, except when a presentation based on liquidity provides more relevant and reliable information. Whatever the method of presentation, an entity should disclose the amount expected to be settled after more than 12 months and less than 12 months.
When an entity supplies goods and services with an identifiable operating cycle, separate classification of current and non-current liabilities highlight liabilities due for settlement in the period. Information regarding the realisation of liabilities is useful in assessing the solvency of an entity as IFRS 7, Financial Instruments: Disclosures, requires disclosure of the maturity dates of financial liabilities. Financial liabilities include trade and other payables. If a liability category combines amounts that will be settled after 12 months with liabilities that will be settled within 12 months, note disclosure is required which separates the longer-term amounts from the 12-month amounts.
Paragraph 69a–d of IAS 1 states that liabilities are to be classified as current if any one of four specified conditions is met. The conditions are:
a) It expects to settle the liability in its current operating cycle
b) It holds the liability primarily for trading
c) The liability is due to be settled within 12 months
d) It does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period.
All other liabilities are to be classified as non-current. IFRS 7 does not deal with the classification of financial liabilities but the disclosure of information that enables users to evaluate the nature and extent of risks arising from financial liabilities to which the entity is exposed.
IFRS 9, Financial Instruments, deals with the classification and measurement of financial liabilities. In October 2010, the International Accounting Standards Board (IASB) published additions to the first part of IFRS 9 on classification and measurement of financial liabilities. The requirements in IAS 39 regarding the classification and measurement of financial liabilities have been retained, including the related application and implementation guidance. This means that there are two measurement categories for financial liabilities, which are fair value through profit or loss (FVTPL) and amortised cost. The criteria for designating a financial liability at FVTPL also remain unchanged.
Some current liabilities such as trade payables and employee costs are part of the normal working capital of the entity and the entity classifies the amounts as current even if they are to be settled outside of the 12-month period. There are some current liabilities that are not part of the working capital cycle but are due for settlement within 12 months or are held for trading. Financial liabilities are an example of this fact.
Financial liabilities are classified as current when they are due for settlement within 12 months, even if the original term was for a longer period than 12 months and an agreement to refinance on a long-term basis is completed after the reporting date but before the financial statements are authorised for issue.
Case study 1
An entity operates in the oil industry. It is constructing and operating an oil rig, which is financed partly by a loan raised in 2010 and the entity classified the loan correctly as a non-current liability in accordance with paragraph 69 of IAS 1. In the statement of financial position at 31 December 2011, the entity reclassified the loan as a current liability.
In the 2011 financial statements, the entity disclosed, as an event after the reporting period, that the loan had been settled with cash received under an oil production agreement. The entity also disclosed that a letter of intent in connection with the agreement had been signed by the end of the 2011 financial year. In the directors' report for the year, the entity stated that the loan was classified as a current liability due to the fact that the loan had been settled in February 2012 when the oil production agreement became legally binding. The original settlement date was 31 December 2015. The entity stated that it had reclassified the loan in accordance with IFRS 7, Financial Instruments: Disclosures.
IFRS 7 applies only to information disclosed in the financial statements and not to the classification of liabilities. Therefore, the standard is not relevant. The classification of the loan as a current liability does not comply with paragraph 69 of IAS 1. In respect of the 2011 financial statements, the oil production agreement, effective in February 2012, was a non-adjusting event after the reporting period as determined in accordance with IAS 10, Events After the Reporting Period.
It can be concluded that the loan should have been classified as a non-current liability in the 2011 statement of financial position because the entity did not meet any of the conditions set out in paragraph 69a–d of IAS 1:
a) The project loan is not a liability which would be settled in the issuer's normal operating cycle (paragraph 69a). The loan is a financial liability providing financing on a long-term basis. It is not part of the working capital used in the entity's normal operating cycle.
b) The issuer did not hold the loan primarily for the purpose of trading but for the purpose of financing the construction of the oilrig (paragraph 69b).
c) The loan was not due to be settled within 12 months after the reporting period (paragraph 69c).
d) The entity had an unconditional right to defer settlement of the liability for at least 12 months after the reporting period, because the loan was not due to be settled within 12 months after the reporting period (paragraph 69d).
Paragraphs 74–76 of the standard address the consequences of a breach of a provision of a long-term loan agreement on or before the end of the reporting period with the effect that the liability becomes payable on demand. In this case, the liability is classified as current, even if the lender has agreed, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach.
Under IAS 1, a liability is classified as current as the entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. However, the liability is classified as non-current if the lender agreed by the reporting date to provide a period of grace ending at least 12 months after the end of the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment.
Case study 2
In December 2010, an entity agreed a 10-year leasing agreement with a leasing company and undertook to comply with certain covenants during the term of the lease agreement. The agreement stipulated that, in the event of a failure by the entity to fulfil any of the contractual obligations, or having failed to rectify any such breach within a one-month period, the lessor had the right to terminate the leasing agreement.
In such a case, the entity would have to pay all unpaid amounts due before the termination of the agreements. As at 31 December 2011, the entity was not in compliance with the covenants stipulated in the leasing agreement. It was additionally established that on 31 January 2012, the entity was still not in compliance with the specified leasing covenants. In the 2011 consolidated financial statements, the debt relating to the leasing company was classified as non-current in accordance with the payment schedules included in the original agreement. The entity had received, from the lessor, a notification confirming the failure to comply with the covenants as of 31 December 2011. Thus, as at 31 December 2011, having failed to fulfil the contractual obligations and being in breach of relevant covenant, the leasing company was entitled to require the entity to repay the debts immediately.
The entity's presentation of the debt as a non-current liability is not in accordance with IAS 1, paragraph 60 that specifies the circumstances in which liabilities are to be classified as current. The amounts outstanding in respect of this arrangement at 31 December 2011 should have been disclosed as a current liability. IAS 1 stipulates that a liability shall be classified as current where it is due to be settled within 12 months after the reporting date, and the entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the end of the reporting period.
Accounting for liabilities may appear to some to be relatively straightforward but simple rules can have significant effects on corporate financial statements.
Graham Holt is an examiner for ACCA, and associate dean and head of the accounting, finance and economics department at Manchester Metropolitan University Business School.