What is the loan’s classification?
A long-term loan did not meet the debt/equity ratio covenant on 31 December. But the covenant compliance result will only be reported to the lender 2 months later based on audited figures.
Generally, a (portion of) loan is presented as a non-current liability if it is not due for repayment within the next 12 months. This classification principle is governed by MFRS 101 ‘Presentation of Financial Statements’.
However, there are grey areas in classifying a loan as a current or non-current liability typically arising from the interpretation of accounting standards and the specific circumstances surrounding a default. Based on the dialogue above, someone may argue that the defaulted loan is:-
- Current liability:
The borrower has breached a provision of the long-term loan, and the loan becomes repayable on demand. - Non-current liability:
The lender has not demanded immediate repayment of the loan. Moreover, the outcome of the breach could only be known 2 months later after the lender has reviewed the compliance result.
With limited guidance in MFRS 101, the classification requirement has led to diverse practices and challenges for the classification of liabilities. In December 2022, the Malaysian Accounting Standards Board (MASB) issued amendments to MFRS 101 ‘Non-current Liabilities with Covenants' (the Amendments) to resolve these issues.
A loan covenant is a condition imposed by a lender that must be adhered to by the parties involved to protect the lender’s interest by ensuring that the borrower maintains specific financial ratios, operational performance levels or other conditions throughout the loan tenure. These covenants always cover metrics such as debt-to-equity ratio, liquidity, profitability and may impose limits on capital expenditures and dividend distributions.
Existing MFRS 101 requires a liability to be classified as current typically when an entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. But in the real world, the right to defer settlement of liability is rarely unconditional because most loan arrangements contain conditions or covenants that the borrower must meet in order to continue deferring settlement beyond 12 months from the reporting date.
The Amendments have deleted the word ‘unconditional’ from the classification principle in MFRS 101. As a result, a liability is classified as non-current if an entity has the right to defer settlement of the liability for at least 12 months from the reporting date. This update may particularly impact convertible loans, roll-over facilities and other debts with covenants.
This article focuses on the classification of loans with covenants as current or non-current. It does not address the classification of other types of liabilities.
Right to Defer Settlement of Liability
The Amendments clarify that:
- The right to defer settlement must have substance and exists at the reporting date
- Only covenants that an entity is required to comply with on or before the reporting date affect the liability classification (even if the compliance assessment is performed after the reporting date)
- Covenants that the entity must comply with after the reporting date do not affect a liability’s classification at the reporting date
- The classification of liabilities is not affected by management’s intentions or expectations about whether the entity will exercise its right to defer settlement or will choose to settle early
