Tuesday 30 November 2021
It seems a long journey this one, and it’s not over yet. When we decided to write a blog piece about the revisions to IAS 1, it wasn’t intended to be a four-parter. However, the way this little mini-series has developed maybe goes to show the complexities faced by those tasked with re-designing just a few paragraphs of an accounting standard (let alone writing a new one). It’s not just the Board that needs to be satisfied with the results of the technical team’s efforts. Stakeholders – preparers, users, analysts – must be assured the revisions that do end up in the final cut really meet the criteria of relevance and usefulness.
Words might just be words, but on paper they can take on different meanings by different readers. Thus, what might appear to be a small change can shift an apparently objective statement into one with subjective and unintended consequences. In essence this is where the Board found itself with its original revision to IAS 1, and why a new exposure draft, Non-current Liabilities with Covenants, Proposed amendments to IAS 1– has been published.
“What problem is the Board trying to solve?” they asked in the Snapshot that accompanies this ED. The answer – stakeholders’ concerns. They hope these latest revisions, what we’ve termed ‘the amendment to the amendment’ will a) improve the information a company presents regarding the split between current and non-current liabilities, specifically where conditions (the covenants) are involved and b) allay the concerns.
Covenants - that’s the real problem; how to ‘correctly’ present financial liabilities where covenants are involved. To be more specific, where lending conditions are contractual terms of debt, but the conditions are not tested until a point after the reporting date – how should the current v non-current distinction be determined?
Here’s a summary of where we are so far on our look into this:
In the first article we introduced the original 2020 amendment, the history behind the re-working and the objective of the changes.
In episode two, we looked at the consequences of that amendment and the stakeholder concerns with respect to debts with covenants.
Episode three introduced ‘the amendment to the amendment’, the re-worked paragraphs of the ED.
This week we’ll have a look at what that re-working (potentially) means in practice.
Now, in terms of what it might mean, it’s worth bearing in mind the following points which the Board now accept and are wanting to reflect in financial information – both presentation and disclosure – to solve ‘the problem’.
- When an entity’s right to defer settlement is subject to compliance with specified conditions within twelve months after the reporting period, the related liability could be repayable either within or after twelve months, depending on whether (or not) the entity complies with those conditions after the reporting date.
- It is therefore impossible to know at the reporting date when the liability will ultimately be repayable, within or outside of that twelve-month timeframe. (This is a really important point and the essence of the Board’s originally revised, and problematic, paragraph 72 (a).)
- Despite this uncertainty, IAS 1 still requires an entity to classify the liability as either current or non-current at the reporting date – it’s a binary ‘Yes/No’ distinction.
- The 2020 amendments specified one way of reflecting conditionality within the constraints of this binary current v non-current model (i.e., by way of paragraph 72 (a)).
- Feedback on that ‘one way’ suggested it could result in classification outcomes that would not provide useful information, for example when covenants are designed to incorporate the expected effects of:
- the seasonality of a company’s business — e.g., covenants that reflect the company’s expected financial position immediately after its high season; and
- the company’s future performance — e.g., covenants that become increasingly strict over the term of a liability.
Let’s now add in points as to the Board’s new thinking:
- When an entity’s right to defer settlement is subject to compliance with conditions after the reporting date, then, on its own, financial information provided by such a binary classification model, is insufficient.
- The classification of a liability as current or non-current does not in itself provide information to users about the potential effects of such conditionality on when the liability is repayable. In other words, as per the original amendment to IAS 1, the uncertainty created by the conditionality is not apparent to users of financial statements.
- Classification as current or non-current: a company would classify liabilities as current or non-current based on its compliance with covenants required only on or before the reporting date.
- A company would:
- present separately non-current liabilities subject to covenants required within 12 months after the reporting date
- Presentation and disclosure: Companies would disclose information that enables investors to assess the risk that the liabilities could become repayable within 12 months including whether:
- they would have complied with covenants at the reporting date
- they expect to comply with them in the future (including how it would do so)
OK, so it looks like the Board is in effect saying this:
- Any covenants that must be complied with on or before the reporting date, are relevant for the purposes of classification at the reporting date, even if they are tested after the reporting date.
- Any covenants that must be complied with after the reporting date, are irrelevant for the purposes of classification at the reporting date, and irrespective of when they are tested.
- Financial liabilities will be split, as they always have been, according to a binary current v non-current classification. In addition, non-current liabilities will be split further between those with and those without lending conditions.
- Additional information – more information – will be disclosed about those debts determined to be non-current for which debt covenants might mean they could well end up being settled within twelve months.
- We got it a bit wrong first time round – didn’t we? (*they’re not the only ones).
Let’s consider an example in the light of these potential new guidelines. This, as per the Snapshot, was the same illustration used by the Interpretation Committee when assessing feedback to the original 2020 amendment. You can see all the 3 Cases here.
A company has a loan repayable in five years. The loan includes a covenant requiring a working capital ratio above 1.0 on 30 June 2022. The loan becomes repayable on demand if the ratio is not met at that specified date. The company reports on 31 December 2021. At that date, the company’s working capital ratio is 0.9. Management expects to meet the minimum working capital ratio by the date on which it is required (30 June 2022).
Based on the wording of original 2020 amendment:
The lending condition is not being complied with at the reporting date. (Relevant)
The lending condition doesn’t need to be complied with until six months later, after the reporting date. (Irrelevant)
At the reporting date it would be impossible to determine whether compliance in six months’ time will occur. (Irrelevant)
No right to defer settlement exists at the reporting date. The loan would be classified as a current liability.
Based on the wording of original 2021 ED:
The lending condition requires compliance after the reporting date. (Relevant)
The lending condition is not being complied with at the reporting date. (Irrelevant)
At the reporting date it would be impossible to determine whether compliance will occur in six months’ time. (Relevant)
A right to defer settlement exists at the reporting date. The loan would be classified as a non-current liability. In addition (1) to it being a non-current liability, it will be presented as a non-current liability with lending conditions. In addition (2) in the notes to the financial statements further information will be given about those conditions:
- whether or not the entity would have complied with those conditions at the reporting date (which are irrelevant for classification anyway and by the way it wasn’t in compliance).
- whether and how it intends to comply with the conditions after the reporting date.
Same example. Two difference responses. You could say that’s a 180° shift. You could say that’s a significant change. You could ask, what’s going on!?!
Well, what’s going to go on, if the ED is adopted, is even more information for readers to assess, and even more lines within, arguably, an already crowded balance sheet. That of course might be ok, but we are already facing the ‘problem’ of information overload, aren’t we?
One thing at least does come to mind here, and it’s that split of non-current financial liabilities between those with and those without lending conditions. As we’ve seen, the reason for this is partly to overcome the perceived, or real, reporting date / covenants / seasonality problem. However, to me this appears quite a departure from historic reporting requirements.
Consider the following:
A company, which wholesales Christmas crackers and chocolate Easter eggs has a loan repayable in five years. The loan includes a covenant requiring a working capital ratio above 1.0 on 30 March 2022. The loan becomes repayable on demand if the ratio is not met at that specified date. The company reports on 30 September 2021. At that date, the company’s working capital ratio is 0.9. Management expects to meet the minimum working capital ratio by the date on which it is required (30 March 2022).
Am I correct in thinking that at 30 September 2021 the inventory of crackers will be rather different from that of eggs? Am I correct in thinking that as we get towards the end of 2021 the inventory of crackers should be getting close to zero (otherwise we’d be rather concerned about the business model – crackers might be the right word for it)? Am I correct in thinking that as we move into 2022, the inventory of eggs will start to decrease, and the inventory of crackers will slowly be on the up again?
My point? We have one figure for the current asset we know as Inventory. We do not split that figure into ‘current - that to be sold on within three months’, ‘current - that to be gone within five months’, ‘current, or maybe not - inventory that might still be around if everyone’s on a diet’….etc. etc. The balance sheet has always had its ‘problems’ - it’s a fundamental characteristic of presenting a sheet of balances at one moment in time. Does sub-splitting items into ‘Non-current With’, ‘Non-current Without’ (for example) remove the problem or just create a new one.
There really is a lot to think about here and writing this has got me thinking.
*Yes, I was wrong too. This is not the last we’ll be saying about IAS 1.
The Board is looking for comments, and comments – constructive of course - we shall give! After a short seasonal break, we’ll have a look at some thoughts for the Board to consider, as they continue to deliberate on these new requirements.
As I said at the top, it’s a long journey this one, and it’s not over yet.
In the meantime,
Click here to read Part 1 of this article
Click here to read Part 2 of this article
Click here to read Part 3 of this article