Background 

In 2020, the IASB issued amendments to IAS 1 titled Classification of Liabilities as Current or Non-current (see our article IASB Issued Amendments to IAS 1 to Clarify the Classification of Liabilities). In the 2020 amendments, among other changes, the IASB clarified that the classification of liabilities as current or non-current is based on rights that exist at the end of the reporting period.   

The 2020 amendments specified how an entity assesses whether it has the right to defer settlement of a liability when that right is subject to compliance with specified conditions (in the amendments referred to as ‘covenants’) within twelve months after the reporting period. As there were concerns about the outcome of applying the 2020 amendments to such covenants, the IASB decided to address these concerns and issued further amendments to IAS 1 in October 2022 (see our article IASB issued amendments to IAS 1 regarding the classification of debt with covenants). 

Key changes 

The amendments to IAS 1 Non-current Liabilities with Covenants (the 2022 amendments) specify that only covenants that an entity is required to comply with on or before the end of the reporting period affect the entity’s right to defer settlement of a liability for at least twelve months after the reporting date (and therefore must be considered in assessing the classification of the liability as current or non-current). Such covenants affect whether the right exists at the end of the reporting period, even if compliance with the covenant is assessed only after the reporting date (e.g. a covenant based on the entity’s financial position at the reporting date that is assessed for compliance only after the reporting date). 

The IASB also specifies that the right to defer settlement is not affected if an entity only has to comply with a covenant after the reporting period. However, if the entity’s right to defer settlement of a liability is subject to the entity complying with covenants within twelve months after the reporting period, an entity discloses information that enables users of financial statements to understand the risk of the liabilities becoming repayable within twelve months after the reporting period. This would include information about the covenants (including the nature of the covenants and when the entity is required to comply with them), the carrying amount of related liabilities and facts and circumstances, if any, that indicate that the entity may have difficulties complying with the covenants. 

We will now demonstrate the application of the above changes using examples. 

Example 1: Impact of expected non-compliance with covenants subsequent to the reporting period end on classification of a liability  

• Entity A prepares its annual financial statements for the year ended 31 December 20X0 and, as of that date, has a loan with a stated maturity on 31 December 20X5.  

• The loan agreement requires compliance with specified covenants. If Entity A is not in compliance with the covenants on a covenant test date, the lender has the right to require the immediate repayment of the amounts drawn down under the loan agreement.  

• The covenants are based on Entity A’s financial position (e.g. liquidity or gearing ratios) at specific test dates, which are at the end of each calendar quarter (i.e. 31 December 20X0, 31 March 20X1 etc.).  

• In the absence of a breach of covenant, the lender cannot demand early repayment.  

• Entity A complies with the covenants on the 31 December 20X0 test date but anticipates that it is highly likely that it will not comply with the covenants on the 31 March 20X1 test date (i.e. it is highly likely that the lender will have the right to demand immediate repayment on 31 March 20X1). 

How should an entity classify a loan in its financial statements for the year ended December 31, 20X0? 

Solution: 

• At 31 December 20X0, Entity A classifies the liability as non-current because, in accordance with IAS 1:72B(b), the required compliance with the covenants on test dates subsequent to the year-end does not affect the classification of the liability as of 31 December 20X0. 

• Entity A also considers the following disclosure requirements in IAS 1:76ZA regarding the risk of non-current liabilities becoming repayable withing 12 months, and the impact of the situation on Entity A’s ability to continue as a going concern when preparing financial statements: 

          a) 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, 

          b) facts and circumstances, if any, that indicate the entity may have difficulty complying with the covenants—for example, the entity having acted during or after the reporting period to avoid or mitigate a potential breach. 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. 

Example 2: Classification of a loan when there is a breach of covenant and a waiver is obtained before the reporting date  

• Entity A prepares its annual financial statements for the year ended 31 December 20X0 and, as of that date, has a loan with a stated maturity on 31 December 20X5 with Bank B.  

• The loan agreement requires compliance with specified covenants. If Entity A is not in compliance with the covenants on a test date, Bank B has the right to require the immediate repayment of the amounts drawn down under the loan agreement. The covenants are based on Entity A’s financial position (e.g. liquidity or gearing ratios) at specific test dates, which are at the end of each calendar quarter (i.e. 31 December 20X0, 31 March 20X1 etc.). In the absence of a breach of covenant, Bank B cannot demand early repayment.  

• Entity A has complied with the covenants on all test dates. However, in mid-December 20X0, Entity A anticipates that it will be in breach of the covenants on 31 December 20X0 and therefore enters into negotiations with Bank B to obtain a waiver with respect to this expected breach. Entity A obtains the waiver on or before 31 December 20X0. As expected, Entity A is in breach of the covenants as of 31 December 20X0. 

How should an entity classify a loan in its financial statements for the year ended December 31, 20X0? 

Solution: 

To determine whether the loan should be classified as current or non-current, Entity A considers whether its right to defer settlement of the liability for at least 12 months after the reporting period has substance and exists at 31 December 20X0:  

• Scenario A – according to the loan agreement, bank B has the option to demand immediate repayment without a time limit, and it waives its right permanently. 

• Scenario B – bank B does not require immediate repayment if the covenants of March 31, 20X1 are met. 

• Scenario C – according to the loan agreement, bank B can only require immediate repayment for a period of 3 months; this right will be waived in connection with covenants as of December 31, 20X0. 

Scenario A – permanent waiver  

If the waiver permanently nullifies Bank B’s right to demand the immediate repayment of the loan as the result of the 31 December 20X0 breach of the covenants, Entity A classifies the loan as non-current. This is because: 

• In accordance with IAS 1:75, when an entity breaches a covenant on or before the end of the reporting period, it ”classifies the liability as non-current if the lender agreed by the end of the reporting period to provide a period of grace ending at least twelve months after the reporting period, within which the entity can rectify the breach and during which the lender cannot demand immediate repayment”.  

• Bank B has relinquished its right to demand the immediate repayment of the loan as a result of the breach of the covenant as of the 31 December 20X0 test date and therefore the requirement in IAS 1:75 is satisfied; and 

• Whilst Bank B will have the right, under the terms of the loan agreement, to demand immediate repayment of the loan if Entity A is in breach on future test dates (some of which are in the next 12 months), the required compliance with the covenants on the test dates subsequent to the year-end does not affect the classification of the liability as of 31 December 20X0. This applies irrespective of whether or not Entity A expects to comply with the covenants on the test dates subsequent to 31 December 20X0.  

• If entity A concludes that a loan should be classified as non-current, it should consider the disclosure requirements in IAS 1:76ZA regarding the risk of non-current liabilities becoming repayable withing 12 months. 

Scenario B – waiver with a grace period of less than 12 months 

• Bank B has waived its right to demand repayment for a three-month period (i.e. until 31 March 20X1), which will be extended until 31 December 20X1 only if entity A meets the 31 March 20X1 covenants (which may be equal to or in addition to those contained in the loan agreement). 

• In this case, the waiver on December 31, 20X0 is conditional on the result of the covenant test on March 31, 20X1, and the loan must be classified as short-term. 

Scenario C – waiver for a duration that corresponds to the duration of lenders’s right to demand immediate repayment of the loan 

• If the terms of the loan are such that the breach of covenants on 31 December 20X0 only permits Bank B to demand repayment for three months, and Bank B has relinquished this right on or before 31 December 20X0, the loan is classified as non-current.  

• Whilst Entity A may be required to comply with covenants on 31 March 20X1, and Bank B has the associated right to demand repayment if the covenants are breached on that date, this is not the result of the breach of covenant on 31 December 20X0. In accordance with IAS 1:72B(b), the required compliance with the covenants on 31 March 20X1 does not affect the classification of the liability as of 31 December 20X0. 

• If entity A concludes that a loan should be classified as non-current, it should consider the disclosure requirements in IAS 1:76ZA regarding the risk of non-current liabilities becoming repayable withing 12 months. 

Summary of the three scenarios