With the end of the summer long-weekend holidays, entities will no doubt be starting to thinking about and plan their upcoming 31 March or 30 June financial reporting year-ends.
In the ongoing COVID environment, one area that NZ IFRS reporting entities should be taking note of is the classification of liabilities as Current or Non-current in the Statement of Financial Position.
Entities are often surprised to learn that classifying liabilities as Current or Non-current is subject to strict and explicit criteria, with very little “wriggle room”.
Not meeting these criteria, and being required to classify certain (often large) liability balances as Current that ordinarily otherwise would have been Non-current (i.e. loans), can have undesirable and problematic practicable consequences, in particular where Working Capital and Liquid Capital are concerned.
To assist entities in navigating this area, BDO International recently released a new IFR Bulletin publication on this topic that included guidance and examples with respect to (i) Trade payables; (ii) Contract liabilities (Deferred revenue); (iii) Convertible loans (i.e. loans with share conversion features), and (iv) Loans with covenants attached, and, (v) Loans with rollover options attached.
This Cheat Sheet provides a summary of the key points of the IFR Bulletin for NZ IFRS reporters to be aware of for the upcoming reporting season.
In particular, this Cheat Sheet comments that entities may need to be proactive contacting their lenders BEFORE reporting date to arrange formal covenant waivers and/or rollovers to be provided (as to ensure certain liability balances are able to (remain to) be classified as Non-current).
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What is covered in this Cheat Sheet
In order to navigate through these areas of accounting, this Cheat Sheet is broken down into the following sections:
Reminder: The Current vs Non-current liability classification criteria
The criteria is including in paragraph 69 of NZ IAS 1 Presentation of Financial Statements (NZ IAS 1).
In order for a liability to be classified as Current, one of the four criteria must be met, otherwise the liability must be classified as Non-current.
These criteria apply to all liabilities, except for deferred tax liabilities, as per paragraph 56 of NZ IAS 1 these must always be classified as Non-current.
The four criteria where a liability is classified as Current are:
- An entity expects to settle the liability in its normal operating cycle.
- The entity holds the liability primarily for the purpose of trading.
- The liability is due to be settled within twelve months after the reporting period.
- The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period.
- 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.
It is criteria (d) that commonly gets the most attention with respect to an entity’s compliance with covenants that are attached to its bank loans (discussed in more detail in 5 below).
Can a single liability have Current vs Non-current portions?
Often loans and lease contracts will have pre-agreed, contractual repayment profiles.
Repayments that are contractually due beyond 12 months will not meet any of the four criteria, whereas repayments that are contractually due within 12 months will meet (d) (and perhaps other criteria).
Classification where an entity’s operating cycle is longer than 12 months
In some industries, the operating cycle of an entity can be longer than 12 months, and as a result certain liabilities within an entity’s working capital (i.e. trade payables, accruals, employee benefit liabilities) may not be expected to be settled within 12 months.
However, this fact alone does not mean that these entities’ liabilities have to be classified as Non - Current – as expanded on in para 70 of NZ IAS 1.
Accordingly, in these situations criteria (a) will be met (despite (c) not being met) meaning that such liabilities are classified as Current.
What if an entity has historical support that it will not have to settle on otherwise due liability in the next 12 months?
In the eyes of NZ IFRS… it doesn’t matter.
If an entity does not hold the unilateral right, within its sole control, to avoid having to settle a liability for at least 12 months, the liability must be classified as Current – as (d) will be met.
This is why the full balance of liabilities associated with refunds, gift cards, customer loyalty points are always classified as Current – as the entity cannot dictate when those liabilities are to be settled, rather, this power lies with the customer.
The impact of loan covenants
Loan covenants act a protectionary “kill switch” to alert a lender that the financial “health” of the entity they have leant to (yje borrower)is heading in the wrong direction, and then (usually) give the lender the right to call in the loan in full (i.e. it becomes legally and contractually, on-demand).
In such a situation, the borrower no longer has a right to unconditionally defer any repayments, and therefore criteria (d) is met.
The only way that an entity can avoid having to classify a loan as current in such a situation would be if the lender formally waived the enforcement of the covenant for 12 months (and thus “restoring” the borrowers unconditional right to defer repayment of the loan).
Because an entity’s Statement of Financial Position is a “snap-shot” of the entity as at the reporting date, and therefore must reflect only that actual facts and circumstances that existed at that date, any such formal waiver of a breach of a loan covenant must be received BEFORE reporting date.
If formal waiver of a breach of a loan covenant is received AFTER reporting date, this event is merely disclosed as a non-adjusting event (in accordance with NZ IAS 10 Events After Reporting Date), and the loan must be classified as Current.
The precise facts and circumstances around when covenants are tested in relation to reporting date will have specific outcomes as to whether the loan meets any of the Current liability criteria.
The IFR Bulletin explores this point through a number of examples, including:
- FAQ 3.1: Where a loan covenant is complied with.
- FAQ 3.2: Where a loan covenant is breached, and a formal waiver is received AFTER reporting date (but before the financial statements are signed.
- FAQ 3.3: Where compliance with a loan covenant is formally waived by the lender BEFORE reporting date.
- FAQ 3.4: Where covenant compliance is required at reporting date, but where the calculation of the covenant is based on the numbers per the signed audited financial statements (that obviously materialise AFTER reporting date).
- FAQ 3.5: Where covenants are tested more frequently that annually at reporting date.
- FAQ 3.6: Where covenants are tested more frequently that annually at reporting date, and where subsequent to reporting date the entity has failed its next covenant test.
The impact of loan rollovers and modifications
An entity may have a clause in its existing loan agreement to “roll” (i.e. extend) the term of the loan.
Paragraph 73 of NZ IAS 1 provides additional guidance with respect to loan roll overs, noting that if an entity both expects, and has the discretion to roll its loan(s), then the rollover should be considered with respect to the four criteria.
In practice, the ability to roll a loan is most likely to be subject to the entity meeting certain requirements and/or thresholds (“tests”) – for example, meeting a specific financial ratio test(s) at the time of the roll over.
Before the end of the loan term (such as, at a reporting date), the assessment as to whether or not an entity has discretion to use its rollover option that is subject to meeting certain tests at the end of the loan term (i.e. in the future) requires consideration of whether the entity would expect to pass the test.
If based on the entity’s results at reporting date it would fail certain tests, but the entity could take reasonable action to rectify this by the time the rollover is applicable, then the ability to roll the loan would still be within the entity’s discretion as at reporting date.
The BDO IFR Bulletin explores this point through a number of examples, including:
- FAQ 4.1: Where the original term of the loan ends within 12 months of reporting date, and there is a rollover clause that is subject to meeting certain tests.
- Based on the entities results at reporting date, it would fail certain tests, but the entity could take reasonable action to rectify this by the time the rollover is applicable.
- Based on the entities results at reporting date, it would fail certain tests, however the entity could not take reasonable action to rectify this by the time the rollover is applicable.
- The tests are perfunctory and/or are within the entity’s control (i.e. requires that the entity not do “something”).
- The tests would be met, however the entity does not intend to roll the loan.
There may also be instances where to original loan did not contain a rollover clause, but where the entity has entered into a rollover agreement before reporting date.
The BDO IFR Bulletin explores this point through a number of examples, including:
- FAQ 4.2: Where the original term of the loan ends within 12 months of reporting date, and before reporting date the entity has entered into a rollover agreement.
- With the original lender.
- With a new lender.
Special consideration: Convertible Notes
Convertible notes are loans (debt instruments) that have clauses in them that provide the lender the option to convert the loan into shares of the borrower (“conversion option”) – rather than the borrower repaying the loan in cash.
Subject to the application of various requirements of NZ IAS 32 Financial Instruments: Presentation, the conversion feature will be classified as either (i) equity, or (ii) a derivative liability.
The BDO IFR Bulletin explores the Current vs Non-current classification of convertible notes through a number of examples, including:
- FAQ 7.1: A convertible note where the conversion option is classified as equity, and is only able to be applied at maturity.
- FAQ 7.2: A convertible note where the conversion option is classified as equity, able to be applied at any point in time prior to maturity.
- FAQ 7.3: A convertible note where the conversion option is classified as a derivative liability, able to be applied at any point in time prior to maturity.
Your go forward requirements
For many entities, having to classify significant liability balances as Current would be problematic, and may have additional consequential impacts.
Because the Current vs Non-current criteria are rules based, and applied based on a snapshot of facts and conditions as at reporting date, they can be unforgiving.
Therefore, where possible, entities should be front-footing any action that they can take to ensure the Current vs Non-current classification is not adversely impacted, including but not limited to:
- Obtaining waivers from current lenders BEFORE reporting date for covenant breaches that the entity believes may occur.
- Ensuring that there is sufficient evidence BEFORE reporting date to support that the entity has appropriate discretion to utilise loan rollover options in existing loans.
- That where loan rollovers are not present in existing loans, that a future rollover is agreed with the original lender BEFORE reporting date.
BDO IFRS Advisory
Members of BDO’s IFRS Advisory department come ready with real life experience in applying IFRS and are therefore well placed to provide entities with the expertise and assistance they require.
For more information as to how BDO Accounting Advisory Services might assist with your entity in navigating this and other areas of IFRS application, please contact James Lindsay at BDO Accounting Advisory Services (email@example.com, ph +64 9 366 8041), and visit our webpage.
Also, visit our dedicated “Adopting NZ IFRS 16 webpage” for more information and resources on NZ IFRS 16.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact your respective BDO member firm to discuss these matters in the context of your particular circumstances.