Meaning of ‘settlement’ when classifying liabilities as current or non-current

New rules for classifying liabilities as current or non-current commence for annual periods beginning on or after 1 January 2024 and apply retrospectively which means that comparatives must be restated.

One of the key amendments to IAS 1 Presentation of Financial Statements clarifies the meaning of ‘settlement’. A liability can only be classified as a non-current liability if, at the end of the reporting period, the entity has a right to defer ‘settlement’ of the liability for at least twelve months after the reporting period. Our recent publication, Amendments to IAS 1 – Clarification of the meaning of ‘settlement’ in the classification of liabilities, provides an in-depth look at these changes.

What do we mean by ‘settlement’?

The amendments to IAS 1 contain new guidance to determine when there has been ‘settlement’ of a liability. This is contained in paragraph 76A.

‘For the purpose of classifying a liability as current or non-current, settlement refers to a transfer to the counterparty that results in the extinguishment of the liability. The transfer could be of:

cash or other economic resources—for example, goods or services; or
the entity’s own equity instruments, unless paragraph 76B applies.’

IAS 1, paragraph 76A

Rolling over loans

Paragraph 76A(a) clarifies that rolling over a loan does not constitute ‘settlement’ because it is an extension of an existing loan facility, which does not involve any transfer of economic resources. Therefore, if all requisite loan covenants have been met at the reporting date, a borrower with the right to roll over a loan for more than twelve months would classify their loan as a non-current liability. Intention to settle is irrelevant.

Settling liabilities by issuing own equity instruments

Under the current requirements in IAS 1, paragraph 69(d), the classification of the debt portion of a convertible note is not affected by conversion features, which give the holder the right to convert (settle) the liability before its maturity date.

However, new requirements in paragraph 76A(b) clarify that settling a liability by issuing an entity’s own equity instruments would generally be a transfer that results in a liability being extinguished. Under the amended paragraph 69(d), the entity must, therefore, have the right to defer settlement of the liability via conversion by the counterparty into the entity’s equity instruments for at least twelve months after the end of the reporting period. This is unlikely to be the case for notes with American-style conversion features because they are exercisable by the holder at any time. However, notes with European-style conversion features may meet the criteria for settlement beyond twelve months.

	American options	European options
Exercisable	Any time before expiration/maturity date	Only on expiration/maturity date
Settlement in next 12 months	Is a possibility	Unlikely unless there is less than 12 months remaining until expiration/maturity

Exceptions for options classified as equity instruments

There is an exception, however, to this new ‘settlement’ principle. Classification of the debt portion of a convertible note as current or non-current is not affected if the conversion option is classified separately from the liability component as an equity component of a compound financial instrument under IAS 32 Financial Instruments: Presentation. This is articulated in paragraph 76B.

‘Terms 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 its classification as current or non-current if, applying IAS 32 Financial Instruments: 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.’

IAS 1, paragraph 76B

Another way of looking at this is as follows. The fact that the holder could choose to have its debt settled by the entity issuing equity instruments within twelve months is ignored. The liability portion of the convertible note is classified as current or non-current based on when repayment is due, not the earliest conversion date.

While the general ‘settlement’ principles result in the debt portion of a convertible note being classified as current if it has American-style conversion features, the exception means it could be non-current if the conversion feature is classified as equity, and the due date for settling the liabilities is more than twelve months after reporting date.

Therefore, whether the conversion option is classified as an equity component of a compound financial instrument or a derivative financial liability drives the classification of the debt portion. The type of conversion features (American or European-style options) is not relevant.

Examples

Our publication contains the following examples to help you contrast the accounting treatment based on the current IAS 1 requirements and the new rules:

Example 1 – Convertible debt with a conversion feature classified as equity
Example 2 - Convertible debt with a conversion feature classified as a derivative financial liability (same facts as Example 1 except the instrument is issued in currency different to the functional currency of the issuer)
Example 3 - Convertible debt with a conversion feature classified as a derivative financial liability (fails the ‘fixed for ‘fixed’ test).

More information

For more information on this topic, please look at our new publication or listen to our recent webinar for further explanation and examples.

Need help?

Classifying loan arrangements and other liabilities as current or non-current may be complex because it is partly driven by the appropriate classification of convertible instruments in the first instance. Please contact our IFRS & Corporate Reporting team if you require assistance.