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.
