Our colleague Felix Wacker-Kijewski used the example of refinancing in the recently published KPMG Corporate Treasury Newsletter to show that the recognition of financial liabilities in the balance sheet is a perennial issue for all treasury accountants.
The amendment to IAS 1 provides for an adjustment to the classification requirements for liabilities as current or non-current for financial years beginning on or after 1 January 2024. Along with the clarification of presentation rules, the amendment also includes new disclosure requirements. These are aimed in particular at improving the disclosures on the nature and extent of any covenants agreed as part of the liabilities. These amendments to IAS 1 not only have an impact on external reporting, but also on internal performance indicators, such as key performance indicators (KPIs), for which the treasury department is sometimes responsible.
To date, IAS 1 stipulated that a liability was to be reported as current if, among other things, the company had no unlimited right to defer settlement of the liability for a period of at least 12 months after the balance sheet date (IAS 1.69). However, this condition was modified by the IASB. It is now sufficient for recognition as a non-current liability if the right described above has “substance” and exists at the end of the financial year (IAS 1.72A). There is no longer a need for an unconditional right to exist.
Whether this right actually exists may be influenced by the obligation to fulfill contractual conditions (covenants). For the purpose of analyzing the disclosure issue, only those conditions that are to be fulfilled by the reporting company before or on the balance sheet date are to be taken into account (IAS 1.72B). This applies regardless of whether compliance with the covenant is recognized only after this date. Any conditions that a reporting entity is not required to meet until after the reporting date are not included in the analysis of whether the liability is recognized as current or non-current. For instance, a contractual condition relating to the reporting entity's financial position 6 months after the reporting date is of no relevance when assessing recognition as at the reporting date.
Should an entity classify a liability as non-current based on an existing right to defer settlement that is dependent on covenants, the amended IAS 1 requires additional disclosures to be made in the notes. This means that information must be disclosed about the risk of non-fulfillment of the covenants and therefore a short-term repayment obligation (IAS 1.76ZA). Among other things, the type and nature of the covenants and the carrying amount of the liabilities concerned must be presented separately. In addition to actual covenant breaches, any indications of potential future covenant breaches must also be disclosed.
Not only that, classification as current or non-current must now be independent of any assessment by management regarding the repayment of the respective liability. To date, it was possible to classify a liability as current even if management did not expect to exercise its unconditional right to defer settlement within 12 months. However, the newly introduced IAS 1.75A specifies clearly that a substantive right to defer settlement existing at the end of the financial year requires long-term recognition irrespective of management's expectation or intention. In such a case, however, additional disclosures may be required in the notes in order to provide readers of the financial statements with information about the expected short-term settlement.
And yet, the amendment to IAS 1 and the adjusted disclosure rules can also have an impact on internal reporting systems and control parameters in addition to external financial reporting. This differentiated consideration of current and non-current liabilities is reflected in some important balance sheet figures, KPIs or even covenants agreed in financing agreements.
Working capital, for example, a key figure for the liquidity available within the operating business, is determined from the difference or the quotient of current assets and current liabilities. This means that, depending on the definition used, the change in presentation triggered by the revision of IAS 1 can result in a change in this key figure, even without significant changes in the operating business.
The same holds true for the liquidity ratios I to III (also known as current, quick and cash ratio). They are also designed to measure the ability to settle current liabilities on the basis of various aggregations on the assets side. A reclassification of what used to be current liabilities as non-current liabilities could result in a synthetic improvement of these key figures without the actual scope for action having changed.
By the same token, it can also influence the parameters of long-term corporate financing. As with other leverage ratios such as debt-to-equity, the long-term debt-to-capitalization ratio measures the proportion of existing capital or assets that is refinanced by long-term debt. It is calculated as the ratio of non-current liabilities relative to the total of non-current liabilities and equity. In line with the liquidity ratios, the adjusted disclosure requirements of IAS 1 can thus lead to a synthetic change in the leverage KPIs. With this in mind, companies should analyze whether it is desirable to use such internal performance measures that are not based on actual economic developments.
Given the wide-ranging effects of the amendment to IAS 1, both in terms of external financial reporting and the influence on internal metrics, this raises further specific questions that need to be examined on a case-by-case basis. The Finance and Treasury Management Team would be happy to help you address these questions and to share practical insights and engage in further discussion.
Source: KPMG Corporate Treasury News, Edition 146, August 2024
Authors:
Ralph Schilling, CFA, Partner, Head of Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Jan-Philipp Wallis, Senior Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
Christopher Wilksen, Assistant Manager, Finance and Treasury Management, Treasury Accounting & Commodity Trading, KPMG AG
