New disclosures for loan arrangements with covenants

For Tier 1 and Tier 2 for-profit entities, 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. Sometimes, an entity classifies a loan as a non-current liability, even though it must comply with one or more loan covenants within twelve months of the reporting date.
 
This month we look at new disclosures for entities when their right to defer settlement for at least twelve months after the end of the reporting period is subject to the entity complying with one or more covenant(s) within twelve months after the reporting period.

What entities need to disclose?

Entities must provide new disclosures in their financial statements if they classify liabilities arising from loan arrangements as non-current, and their right to defer settlement of those liabilities for at least twelve months is subject to them complying with one or more covenant(s) within twelve months after the reporting period.

The new disclosures (for both Tier 1 and Tier 2 reporting entities) are contained in paragraph 76ZA of the amendments to IAS 1 Presentation in Financial Statements. Entities must disclose information in the notes to the financial statements that enables users of financial statements to understand the risk that liabilities could become repayable within twelve months after the reporting period. Specifically, entities must disclose:

  • Information about the covenants (including the nature of the covenants and when the entity is required to comply with them) and the carrying amount of related liabilities
  • Facts and circumstances, if any, that indicate the entity may have difficulty complying with the covenants. Such facts and circumstances could also include the fact that the entity would not have complied with the covenants if they were to be assessed for compliance based on the entity’s circumstances at the end of the reporting period.

Examples

We use the base fact pattern below to illustrate what the appropriate disclosures might look like in two alternate scenarios.

Fact pattern

Entity A has a bank loan repayable after five years. The loan arrangement requires Entity A to have a working capital ratio above 1.2 as at every 30 June, failing which the loan becomes repayable on demand.

Entity A's annual reporting period ends on 31 December.

Entity A met the covenant test on 30 June 20X1 with a working capital ratio of 1.25. On 31 December 20X1, Entity A’s working capital ratio is 1.15.

The covenant test on 30 June 20X2 is after the reporting period and does not affect whether Entity A has the right to defer settlement for at least twelve months as at 31 December 20X1.

The liability is classified as non-current on 31 December 20X1.

The facts below are specific to each scenario:

  • Scenario 1
    • Historically Entity A’s highest turnover is achieved during the first six months of the year
    • On the date the financial statements were authorised for issue, Entity A had achieved its budgeted sales targets for the first months of the new financial year
    • On the date the financial statements were authorised for issue, Entity A had a working capital ratio of 1.18
  • Scenario 2
    • After year-end, demand for Entity A’s products in Jurisdiction Z, Entity A’s largest market, had declined
    • Entity A approached its bank after year-end for a waiver of a potential breach of covenant at its next testing date, 30 June 20X2. Negotiations were advancing well on the date the financial statements were authorised for issue.
    • On the date the financial statements were authorised for issue, Entity A had a working capital ratio of 1.10.

The following are some illustrative disclosures required by IAS 1.76ZA

Illustrative disclosure 1

Note XX Loans and borrowings (extract)

Entity A’s loan from Bank B (20X1: $950,000; 20X0: $935,000) is repayable on 31 December 20X5. The contract includes a covenant that requires a working capital ratio above 1.2 on 30 June every year. The loan will be repayable on demand if the covenant is not met.

Entity A’s working capital ratio on 30 June 20X1 was 1.25 and the covenant requirement was complied with. Therefore, on 31 December 20X1, the loan is not repayable on demand and is classified as non-current.

Entity A’s working capital ratio on 31 December 20X1 is 1.15 which does not meet the covenant requirement for the working capital ratio to be above 1.2.

Historically, Entity A has experienced the highest turnover during the first six months of the year. In order to comply with the future covenant test as at 30 June 20X2, Entity A will need to meet expected sales targets over this period next year. If the entity does not comply with the covenant test as at 30 June 20X2, the loan will become repayable on demand.

At the time these financial statements are authorised for issue, Entity A has met its expected sales target, and its working capital ratio has increased to 1.18.

Illustrative disclosure 2

Note XX Loans and borrowings (extract)

Entity A’s loan from Bank B (20X1: $950,000; 20X0: $935,000) is repayable on 31 December 20X5. The contract includes a covenant that requires a working capital ratio above 1.2 on 30 June every year. The loan will be repayable on demand if the covenant is not met.

Entity A’s working capital ratio on 30 June 20X1 was 1.25 and the covenant requirement was complied with. Therefore, on 31 December 20X1, the loan is not repayable on demand and is classified as non-current.

Entity A’s working capital ratio on 31 December 20X1 is 1.15 which does not meet the covenant requirement for the working capital ratio to be above 1.2.

At the time these financial statements are authorised for issue, Entity A’s working capital ratio has declined to 1.10 due to a reduction in demand in jurisdiction Z. Entity A has approached Bank B for a waiver of the potential breach of covenant and negotiations for a waiver are at an advanced stage. However, if Entity A does not comply with the covenant test as at 30 June 20X2 and the breach of covenant is not waived by Bank B, the loan will become repayable on demand.

Based on the facts and circumstances, some of the disclosure requirements of IFRS 7 Financial Instruments: Disclosures (e.g. IFRS 7.18-19 on defaults and breaches, disclosures on capital management) and IAS 1 Presentation of Financial Statements (e.g. IAS 1.25 related to going concern) or FRS-44 New Zealand Additional Disclosures (e.g. FRS-44.12A.1 and .12A.2 related to going concern) may apply. The above examples do not address these disclosure requirements.

More information about the amendments

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, quarterly and in order to roll over an obligation for an existing loan arrangement, as well as other common practice issues.  

We are here to help

Classifying your loan arrangements as current or non-current may be complex, particularly when covenant tests are involved. 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.