Entities may have to reclassify their borrowings at 31 December 2024 – Part 4

New rules for classifying liabilities as current or non-current commence for annual periods beginning on or after 1 January 2024. One of the most complex areas of the new rules relates to entities classifying loan arrangements with loan covenants.
 
BDO’s recent publication, IFRS Accounting Standards in Practice - Classification of loans as current or non-current, includes a flow chart and numerous examples to help you determine the correct classification of your loan arrangements. Our previous articles showcased examples where compliance with loan covenants is required at the end of or after the reporting period, before the end of the reporting period, and quarterly. This month, we look at examples where an entity has a right to roll over an obligation for an existing loan arrangement.

The following diagram summarises whether loan covenants will affect the classification of your loan arrangements (IAS 1 Presentation of Financial Statements, paragraph 72B):

To classify a loan as a non-current liability at the reporting date, it must meet any loan covenant test required on or before the end of the reporting period.

If the entity breaches a loan covenant before the reporting date such that the loan becomes repayable on demand, the loan would be classified as a current liability because the borrower does not have a right to defer settlement. However, if the entity obtains, before the end of the reporting period, a waiver for the breach, or a period of grace whereby the borrower agrees not to demand repayment for at least twelve months after the end of the reporting period, the loan is classified as a non-current liability. Please refer to our previous article, which explains the difference between a waiver and a period of grace in more detail. 

Right to roll over an existing loan arrangement

Our publication includes a flowchart to help you determine the appropriate classification of a loan arrangement when an entity has a right to roll over an obligation for an existing loan arrangement. 

IAS 1, paragraph 73 outlines the requirements for classifying loan arrangements with roll over clauses. If an entity has the right, at the end of the reporting period, to roll over an obligation for at least twelve months after the reporting date under an existing loan facility, the loan is classified as a non-current liability. This applies even if the loan would otherwise be due within a shorter period. However, if the entity does not have such a right, it does not consider the potential to refinance the obligation with another financier, and the loan is classified as a current liability.

While the requirements of IAS 1, paragraph 73 appear relatively straight-forward, complications arise when the right to roll over a loan is subject to the entity complying with loan covenants on, or prior to, the roll over date. A question arises as to how the related covenants should be treated. Does paragraph 73 of IAS 1 trump paragraph 72B(b), or vice versa?

BDO’s view is that these two paragraphs are complementary. If an entity has the right to roll over an obligation for at least twelve months after the reporting period, the obligation will be classified as a non-current liability, irrespective of whether the roll over is subject to a future covenant test. 

However, the loan would be classified as a current liability if the entity fails to comply with a covenant on or before the reporting date, resulting in the lender obtaining the right to demand immediate repayment. Please refer to sections A to C of our publication for more information.

Examples

Our publication illustrates several examples of different roll over scenarios and how loan classification is impacted at the reporting date. For each example, the publication uses the above flow chart and walks you through step-by-step to arrive at the correct loan classification. For all these examples, the answers to the following questions are ‘Yes’:

  • Question 1 - Does the liability arise from a loan arrangement?
  • Question 2 - Is the loan scheduled to be repaid within the next 12 months?
  • Question 3 - At the end of the reporting period, does the entity have a right to roll over the obligation for at least 12 months after the end of the reporting period?

Therefore, our analysis below will only consider Questions 4 to 6.

Right to roll over an obligation with no loan covenants

Example D(I) illustrates a scenario whereby Entity A obtains a loan on 1 July 20X1. The loan is repayable in full after three years, i.e. on 30 June 20X4.

The loan arrangement gives Entity A the right to roll over the loan with the same lender for a period of another three years.  

Entity A is not required to comply with a covenant on or before the end of the current reporting period, 31 December 20X3. Therefore, the answer to Question 4 is ‘No’. 

The loan is classified as a non-current liability on 31 December 20X3.


Annual right to roll over an obligation with half-yearly covenant tests

Base fact pattern for Examples D(II)-1, D(II)-2(a) and D(II)-2(b)

Entity A has a loan from Bank B. The loan is a short-term facility that includes an annual roll over on 30 June.

The loan arrangement requires Entity A to have a current ratio of at least 1.5 on 30 June and 31 December. Failure to meet the loan covenant on either date gives Bank B the right to demand immediate repayment of the loan.

The roll over on 30 June is subject to Entity A meeting the current ratio test. Entity A’s annual reporting period-end is 31 December. 

The table below illustrates the analysis of four variations on this base fact pattern, showing how the respective loan arrangements are classified as at 31 December 20X1.

 

Example D(II)-1

Example D(II)-2(a)

Example D(II)-2(b)

Example D(II)-3

 

Current ratio as at 31 December 20X1 is 1.7.

Current ratio as at 30 June 20X2 is expected to be 1.75.

Current ratio is expected to be 1.3 as at 31 December 20X1.

Bank B provides a waiver for anticipated breach on 15 December 20X1.

Current ratio as at 30 June 20X2 is expected to be 1.6.

Current ratio is expected to be 1.3 as at 31 December 20X1.

Bank B provides a waiver for anticipated breach on 15 December 20X1.

Current ratio as at 30 June 20X2 is expected to be 1.4.

Same fact pattern as above except that the covenant is tested as at 30 November and 31 May each year.

Current ratio is 1.3 as at 30 November 20X1.

Bank B provides a waiver for the breach on 15 December 20X1.

Current ratio as at 31 May 20X2 is expected to be 1.7.

Question 4:

Is the entity required to comply with a covenant on or before the end of the reporting period, with failure to comply resulting in the lender having the right to demand repayment? 

Yes

No

No

Yes

Note: If the  test was waived prior to the point at which the covenant was to be tested, answer ‘NO’. The covenant test was not waived prior to the point at which the covenant was to be tested.The covenant test was waived prior to the point at which the covenant was tested.The covenant test was waived prior to the point at which the covenant was tested.The covenant test was not waived prior to the point at which the covenant was to be tested.

Question 5:

Did the entity comply with the covenant?


Yes


N/A


N/A


No

Question 6:

Has the lender provided a waiver for the covenant violation by the end of the reporting period?

N/A

N/A

N/A

Yes

Classification

Non-current liability

Non-current liability

Non-current liability

Non-current liability

From the above examples, we can see:

  • IAS 1, paragraph 72B(b) applies to the future covenant test on 30 June 20X2. The 30 June 20X2 covenant test does not affect Entity A’s right to defer settlement for at least twelve months at the end of the reporting period (31 December 20X1).
  • Classification of the loan as current or non-current at the end of the reporting period is also not affected by Entity A’s expectation of whether it will or won’t comply with a future covenant.
  • Where an entity classifies a liability as a non-current liability at the reporting date, and the entity’s right to defer settlement of that liability for at least twelve months depends on it complying with future loan covenants, extra disclosure must be provided. Paragraph 76ZA of IAS 1 requires information that enables users of financial statements to understand the risk that the liability could become repayable within twelve months of the reporting date.
  • It makes no difference whether a waiver is received from the lender prior to a breach or after a breach, so long as the waiver is in place by the end of the reporting period.

Annual right to roll over an obligation with annual covenant tests

Base fact pattern for Examples D(III)-1 and D(III)-2 

Entity A has a short-term loan with an annual roll over every 30 September.

The roll over is subject to Entity A’s current ratio being at least 1.5 as at 30 September each year.

Entity A’s annual reporting period-end is 31 December. 

The table below illustrates the analysis of two variations on this base fact pattern and shows how the respective loan arrangements are classified as at 31 December 20X1.

 

Example D(III)-1

Example D(III)-2

 

Current ratio as at 30 September 20X1 is 1.7.

Covenant test is met and loan is rolled over for one year.

Next covenant test is on 30 September 20X2.

Current ratio as at 30 September 20X1 is 1.3 so covenant test is breached.

Bank provides a waiver for the breach on 31 October 20X1.

 Next covenant test is on 30 September 20X2.

Question 4:

Is the entity required to comply with a covenant on or before the end of the reporting period, with failure to comply resulting in the lender having the right to demand repayment?



Yes



Yes

Note: If the covenant test was waived prior to the point at which the covenant was to be tested, answer ‘NO’. The covenant test was not waived prior to the point at which the covenant was to be tested.The covenant test was not waived prior to the point at which the covenant was to be tested.

Question 5:

Did the entity comply with the covenant?


Yes


No

Question 6:

Has the lender provided a waiver for the covenant violation by the end of the reporting period?


N/A


Yes

Classification

Non-current liability

Non-current liability

Although the covenant in Example D(III)-2 was not met as at 30 September 20X1, it was waived by the bank prior to the reporting date, 31 December 20X1. Entity A, therefore, has a right to roll over the loan for at least twelve months after the reporting period under an existing loan facility, and the loan is therefore classified as a non-current liability on 31 December 20X1. This is despite the next loan covenant being tested in nine months’ time on 30 September 20X2. BDO’s view is that IAS 1, paragraph 72B(b) applies to this future covenant test, and it does not affect Entity A’s right to defer settlement for at least twelve months as at 31 December 20X1. 

Negotiations for a waiver of a breach are ongoing at the end of the reporting period (Example D(IV))

Entity A has a long-term loan that is due for repayment on 31 December 20X1, which is the end of the reporting period.

The loan arrangement provides Entity A with a right to roll over the loan for a period of five years if a working capital covenant is met as at 31 December 20X1.

Entity A does not meet the covenant as at 31 December 20X1.

At the end of the reporting period, Entity A and the lender are negotiating whether to extend the loan for a period of two years, however, discussions are ongoing.

Entity A is required to comply with a covenant at the end of the reporting period, 31 December 20X1. Therefore, the answer to Question 4 is ‘Yes’.

Entity A did not comply with the covenant, so the answer to Question 5 is ‘No. 

The lender did not provide a waiver for the covenant violation by the end of the reporting period. Therefore, the answer to Question 6 is ‘No’.

The loan is classified as a current liability as at 31 December 20X1.

The fact that Entity A and the lender are negotiating an extension of the loan as at 31 December 20X1 does not affect the above analysis. If the lender agrees to extend the loan term after the end of the reporting period, but before the financial statements are signed, this is considered a non-adjusting post-balance date event because Entity A did not have the right to defer settlement for at least twelve months at the end of the reporting period.

Disclosure about standards issued not yet effective

We remind entities preparing Tier 1 general purpose financial statements of the requirement to disclose and quantify the impact of amending standards that will take effect in a later period. Entities with loan arrangements subject to loan covenants will have to assess the implications of these IAS 1 changes on their borrowings and disclose the effect on the comparative and opening balance sheets for reporting periods starting before 1 January 2024. 

More information

For more information on this topic, please look at our new publication.

Need help?

Classifying loan arrangements and other liabilities as current or non-current may be complex, particularly when they involve roll overs and covenant tests. Please contact our Financial Reporting Advisory team for help. 

For more on the above, please contact your local BDO representative.

This article has been based on an article that originally appeared on BDO Australia, read the original article here.