Classification of Liabilities as Current or Non-current – Interaction with convertible debt

IAS 1 Presentation of Financial Statements sets out the circumstances in which an entity is required to classify a liability as current.  One of those circumstances, set out in sub-paragraph 69(d), is when the entity does not have an unconditional right to defer settlement of the liability for at least 12 months.

In January 2020, the International Accounting Standards Board (IASB) issued a proposed amendment to IAS 1 Presentation of Financial Statements (IAS 1) to clarify what the right to defer settlement for at least 12 months means when a liability is subject to the entity complying with specified conditions, such as debt covenants.  Following concerns raised by stakeholders, the original amendment made in January 2020 was further amended in October 2022 to clarify that if a covenant test takes place within 12 months of the balance sheet date, then it does not result in the liability being classified as non-current, unless the test is based on the entity’s financial position at or before the financial reporting date.  So, for example, a company with an annual reporting date of 31 December will not be required to present a liability as current purely as a result of having to meet a covenant based on financial performance or position 6 months later as at 30 June in the following financial period.

However, what may have gone unnoticed as a result of the October 2022 amendment to the January 2020 amendment to clarify how to factor in covenant compliance to the current versus non-current classification is the January 2020 amendment also added paragraph 76B.  This states that “[t]erms of a liability that could, at the option of the counterparty, result in its settlement by the transfer of the entity’s own equity instruments do not affect the transfer of the entity’s own equity instruments as current or non-current if, applying IAS 32 Financial statements: Presentation, the entity classifies the option as an equity instrument, recognising it separately from the liability as an equity component of a compound financial instrument [emphasis added]”.

Some entities may have issued convertible debt in which the conversion feature breaches the fixed-for-fixed principle in IAS 32 Financial statements: Presentation (IAS 32) resulting in either: (i) the conversion feature being accounted for as an embedded derivative liability: or (ii) the entire financial liability being designated at fair value through profit or loss.  Such accounting is required, for example, when the convertible debt in question is denominated in a currency different to that of the reporting (issuing) entity’s functional currency.

Entities that have issued convertible debt in which the conversion feature does not fall to be accounted for as equity will have to present the debt owed as a current liability, whereas hitherto they may have presented it as non-current.  This change, brought in by the January 2020 amendment, remains intact notwithstanding the October 2022 amendment.

Although originally intended to be effective for periods beginning on or after 1 January 2022, the advent of Covid coupled with the need to amend the original January 2020 amendment has resulted in the amendments to IAS 1 being deferred until periods beginning on or after 1 January 2024.