IASB Exposure Draft ED/2021/9 Non-current Liabilities with Covenants – Proposed amendments to IAS 1

Page 1 of 8Our Ref.: C/FRSCSent electronically through the IASB Website (www.ifrs.org)

18 March 2022Dr Andreas BarckowInternational Accounting Standards BoardColumbus Building7 Westferry CircusCanary WharfLondon E14 4HDUnited KingdomDear Andreas,IASB Exposure Draft ED/2021/9Non-current Liabilities with Covenants – Proposed amendments to IAS 1The Hong Kong Institute of Certified Public Accountants (HKICPA) is the only bodyauthorised by law to set and promulgate standards relating to financial reporting, auditing,and ethics for professional accountants, in Hong Kong. We are grateful for the opportunityto provide you with our comments on this Exposure Draft (ED).The HKICPA supports the IASB’s effort to address the concerns raised by stakeholdersabout the outcomes and potential consequences of Classification of Liabilities as Currentor Non-current (2020 amendments) and the related tentative agenda decision published bythe IFRS Interpretations Committee in December 2020.Having said that, we consider that the principle introduced in the ED for the classificationof liabilities that are subject to specified conditions within twelve months after the end of thereporting period has not been sufficiently clear, and has inadvertently created the followingissues, among others, with the introduction of paragraphs 72B and 72C of the ED.Firstly, the HKICPA has significant concerns over the notion of “unaffected by the entity’sfuture actions” as currently drafted in paragraph 72C(b) of the ED. This is a new concept inthe context of IFRS Standards, yet the ED only provides limited guidance on how to applythis new concept. We consider that the ED is not yet clear as to how an entity assesses thenature and extent of an entity’s “ability to affect”, and this may lead to a risk of wideinterpretation. In addition, questions were raised as to whether common covenants areconsidered to be “conditions” or events “unaffected by the entity’s future actions”, andwhether paragraph 72B or paragraph 72C(b) of the ED should be applied in those cases.We note that paragraphs 72B and 72C of the ED are not necessarily mutually exclusiveand this is problematic as they would lead to different classification outcomes on the samefacts and circumstances. In light of the above, we strongly recommend that the IASB testthe proposals with real-life examples and assess whether the resulting outcomes are in linewith what the IASB intends to achieve and the ED’s objectives; clarify the interactionbetween paragraphs 72B and 72C of the ED; and clarify the notion of “unaffected by theentity’s future actions” in paragraph 72C(b) and the term “conditions” in paragraph 72B withillustrative examples.Page 2 of 8Secondly, the HKICPA disagrees with the examples of financial guarantee contracts andinsurance contract liabilities stated in paragraph 72C(b) of the ED as this would imply thatall financial guarantee contracts and insurance contract liabilities must be classified entirelyas current liabilities applying the proposals. We consider that classifying the entireinsurance contract liabilities as current liabilities does not reflect the business substance ofthe insurance contracts, is inconsistent with the requirements in IFRS 17 InsuranceContracts and does not provide relevant information to users of financial statements. Wealso do not consider that all financial guarantee contracts should be classified as currentliabilities in all circumstances. Accordingly, we recommend the IASB consider seekingfeedback from the insurance industry regarding the classification of insurance contractliabilities and the interaction between the proposal and IFRS 17, and re-consider whetherclassifying all financial guarantee contracts and insurance contract liabilities as currentliabilities, as implied by paragraph 72C(b) of the ED, is appropriate.Thirdly, the HKICPA disagrees with the proposed separate presentation requirement inparagraph 76ZA(a) of the ED. Instead, we agree with the Alternative Views in paragraphsAV3 and AV4 of the ED that the disaggregation requirements in paragraph 55 of IAS 1Presentation of Financial Statements already set out the principles for presenting additionalline items in the statement of financial position when it is relevant to an understanding ofan entity’s financial position. The proposed separate presentation seems to contradict theprinciple-based nature of IFRS Standards. We believe that identifying non-current liabilitiesthat are subject to covenants through disclosures in the notes to the financial statements(as proposed in paragraph 76ZA(b) of the ED subject to our comments on that paragraph)

would be sufficient for users to identify and assess the risk of those liabilities. Hence, wesuggest that the IASB remove the separate presentation requirements in paragraph 76ZA(a)

of the ED.Lastly, the HKICPA does not support the disclosure regarding future compliance withcovenants as proposed in paragraph 76ZA(b)(iii) of the ED. This is because we considerthat the costs of preparing such disclosure may outweigh its benefits to the users of financialstatements, that it requires disclosure of an entity’s future behaviour which is arguablybeyond the remit of a standard setter and that it may potentially trigger legal obligation ifthe final outcome is different from that disclosed in the financial statements. We recommendthe IASB replace such disclosure with the key factors that may affect the ability of an entityin complying with the conditions after the reporting date. We consider these suggesteddisclosures would be objective and provide more useful information for users of financialstatements to make their own decisions.Our detailed comments are provided in the Appendix.If you have any questions regarding the matters raised in this letter, please contact me(ceciliakwei@hkicpa.org.hk), Katherine Leung (katherineleung@hkicpa.org.hk) or Joni Kan(jonikan@hkicpa.org.hk), Associate Directors of the Standard Setting Department.Sincerely,Cecilia KweiDirector, Standard Setting DepartmentPage 3 of 8Work undertaken by HKICPA in forming its views:

The HKICPA:

(a) issued an Invitation to Comment on the ED on 22 November 2021 to our stakeholders;

(b) sought input from its Disclosure Initiatives Advisory Panel and Financial InstrumentsAdvisory Panel, which are mainly comprised of technical and industry experts andauditors from large accounting firms; and(c) developed its views through its Financial Reporting Standards Committee, havingreflected on its respondents’ views. The Committee comprises preparer representativesfrom various industry sectors, investors, regulators, and technical and industry expertsfrom small, medium and large accounting firms.Detailed comments on IASB ED/2021/9Question 1 – Classification and disclosure (paragraphs 72B and 76ZA(b))

Classification (paragraphs 72B and 72C)

1) The HKICPA supports the IASB’s effort in addressing the concerns raised bystakeholders about the outcomes and potential consequences of the 2020amendments and the related tentative agenda decision published by the IFRSInterpretations Committee in December 2020.2) Having said that, we consider that the principle introduced in the ED for theclassification of liabilities that are subject to specified conditions within twelve monthsafter the end of the reporting period has not been sufficiently clear, and hasinadvertently created the following issues with the introduction of paragraphs 72B and72C of the ED.The notion of “unaffected by the entity’s future actions”

3)

We have significant concerns over the notion of “unaffected by the entity’s futureactions” as currently drafted in paragraph 72C(b) of the ED. This is a new concept inthe context of IFRS Standards, yet the ED only provides limited guidance inparagraphs BC19 and 20 on how to apply this new concept. We consider that the EDis not yet clear as to how an entity assesses the nature and extent of an entity’s “abilityto affect”, and this may lead to a risk of wide interpretation.4)

In addition, some respondents questioned the meaning of “conditions” in paragraph72B when determining the scope of paragraph 72B. Specifically, questions wereraised as to whether the following common covenants are considered to be“conditions” or events “unaffected by the entity’s future actions”, and whetherparagraphs 72B or 72C of the ED should be applied in these cases.i.Loan repayment subject to “completion of IPO” or “a change of control”;

ii.Liability that is repayable when, for example,a) the entity fails to meet certain project milestones;

b) the entity’s credit rating deteriorates to a certain level; orc) the entity fails to identify the existence of mineral reserves;

iii.Financial covenants based on the fair value of collateral;

iv.A very ambitious target, for example, increasing revenue by ten times overthe last year; andv.Liability with multiple conditions, for example, having both a financialcovenant and a “material adverse change in borrower’s operation" clause.5)

We and our respondents noted that paragraphs 72B and 72C of the ED are notnecessarily mutually exclusive. This is problematic as they would lead to differentAppendixPage 4 of 8classification outcomes.6)

For example, a loan is contractually repayable in five years, but it is repayable ondemand if there is a change in control of the entity at any time.i.It is arguable that paragraph 72C(b) of the ED is not applicable to such aloan because the entity’s future actions may to a greater or lesser extent“affect” whether the controlling shareholder disposes all or some of its equityinterest in the entity resulting in a loss of control.ii.If one takes the view that retaining the same controlling shareholder is at thediscretion of the controlling shareholder, then such a loan would beclassified as current applying paragraph 72C(a) of the ED.iii.If, in contrast, one takes the view that retaining the same controllingshareholder is a “condition” that must be complied with to allow the entity todefer the settlement of the loan for at least twelve months after the reportingperiod, then as long as there is no change of control at the reporting date,such loan would be classified as non-current applying paragraph 72B(b) ofthe ED.7)

As seen from the above example, applying paragraph 72C(a) or 72C(b) (if a changeof control is considered to be an event “unaffected by the entity’s future actions”) ofthe ED, a long-term loan that is repayable on demand upon a change of control wouldbe classified as current even when there is no actual breach at the reporting date.This outcome seems to contradict the ED’s objective that only an actual breach ofcovenants at the reporting date would lead to a current classification.8)

In addition, some respondents shared that under the existing requirements in IAS 1Presentation of Financial Statements, entities usually apply paragraph 74 of IAS 1 toa long-term loan that is repayable on demand upon change of control and classifysuch loan as non-current when there is no change of control (i.e. no actual breach).If the IASB were to proceed with the proposals, there would be a significant changeto the current practice.9)

Another common scenario is that a long-term loan is repayable on demand if thecurrent ratio is below a certain threshold or if there is a material adverse change inthe entity’s operation (i.e. with multiple conditions).i.Applying paragraph 72B(b) of the ED, such loan would be classified as non-current if the entity complies with both conditions at the reporting date.ii.If one takes the view that a material adverse change in the entity’s operationis unaffected by the entity’s future actions, such loan would be classified ascurrent applying paragraph 72C(b) of the ED.10) As noted from this example, applying paragraph 72B and 72C separately to loanswith multiple conditions could lead to opposite answers – which classification outcomeprevails in this case?11) In light of the above, the HKICPA strongly recommends that the IASB:

i.Test the proposals with real-life examples (with reference to the examples inparagraph 4 above) and assess whether the resulting outcomes from theproposals are in line with what the IASB intends to achieve and the ED’sobjectives;

ii.Clarify the notion of “unaffected by the entity’s future actions” in paragraph72C(b) and the term “conditions” in paragraph 72B;

iii.Clarify the interaction between paragraphs 72B and 72C of the ED; andiv.Clarify how the proposals in the ED should be applied to the examples inPage 5 of 8paragraphs 4, 6 and 9 above.Examples in paragraph 72C(b)

12) Paragraph 72C(b) of the ED specifies that financial guarantees and insurancecontract liabilities are examples that would fall within the scope of this paragraph. Thismay imply that all financial guarantee contracts and insurance contract liabilitieswould be entirely classified as current liabilities applying the proposals, which maylead to unintended consequences.13) We disagree with classifying the entire insurance contract liabilities as currentliabilities for the following reasons:

i.An insurance contract usually has a long policy period, especially a lifeinsurance contract, and its liability is determined as the present value ofexpected future cash flows (among others). Classifying the insurance liabilityas current would presume that all uncertain future events (e.g. claims) wouldhappen within twelve months after the reporting period. This does not reflectthe business substance of the insurance contracts and does not providerelevant information to users of financial statements.ii.A long-term insurance contract often has a surrender clause stipulating thata cash surrender value will be paid to the policyholder upon voluntarytermination or occurrence of an insured event. Given the nature of long-terminsurance and the existence of a surrender penalty, policyholders wouldnormally suffer losses if they surrender an existing life insurance policy,particularly during the early years of the policy. In other words, only a smallportion of the surrender value inherent in the insurance contract liability isexpected to be settled within twelve months after the reporting period. Underthese circumstances, classifying the whole insurance contract liability (themeasurement of which might assume the repayment of a much highersurrender value beyond twelve months) as current might result in a netcurrent liability position for the insurer (if it chooses to present thecurrent/non-current distinction on the statement of financial position), whichwould not be a true and fair presentation of the financial position of theinsurance companies.iii.According to paragraph 32 of IFRS 17 Insurance Contracts, an insurancecompany measures a group of insurance contracts at the total of twocomponents: a) the present value of fulfilment cash flows (FCF), and b) thecontractual service margin (CSM). It is unclear whether paragraph 72C(b) ofthe ED should be applied to the insurance contract liability as a whole, or tothe different components separately, given FCF is associated with cash flowswhereas CSM has a similar nature to deferred profit. Hence, classifying theentire CSM component as a current liability for an insurance contract with acoverage period of more than one year would be misleading.iv.Insurance companies normally invest in non-current assets so as to matchwith the liquidity profile of their liabilities. Classifying the whole insurancecontract liability as current could be misleading.v.Paragraph 72C(b) of the ED implies that entities classify the entire insurancecontract liabilities as current liabilities based on the worst case scenario. Thisis, however, inconsistent with the liquidity disclosure for insurance contractliabilities under paragraph 132(b) of IFRS 17 which is based on the estimatedtiming of future cash flows.14) We also do not agree that financial guarantee contracts should be classified ascurrent liabilities in all circumstances. For example, the reporting entity is a guarantorand a related party or business partner of the borrower. It is possible that such specialPage 6 of 8relationships may allow the guarantor to affect whether the borrower could settle itsloans on time, e.g. through the reporting entity’s advancing money to the borrower,other forms of prepayments or business activities.15) Given the above, the HKICPA recommends that the IASB consider seeking feedbackfrom the insurance industry regarding the classification of insurance contract liabilitiesand the interaction between the proposal and IFRS 17, and re-consider whetherclassifying all financial guarantee contracts and insurance contract liabilities ascurrent liabilities, as implied by paragraph 72C(b) of the ED, is appropriate. The IASBcould also consider one of our respondent’s suggestion of introducing an exceptionby classifying insurance contract liabilities on the same basis as the liquiditydisclosure requirements under paragraph 132(b) of IFRS 17.Interaction between paragraph 72B(a) of the ED and paragraphs 74 and 75 of IAS 116) Some respondents raised concerns over the interaction between paragraph 72B(a)

of the ED and paragraphs 74 and 75 of IAS 1. For example, an entity enters into afive-year loan with a specific condition to be complied with quarterly. The entitybreaches the condition on 31 March 20X1 and obtains a waiver for twelve months till31 March 20X2. The entity complies with the condition at its reporting date (31December 20X1).17) Applying paragraph 72B(a) of the ED, the entity would classify the loan as non-currentgiven the condition is met at the reporting date. However, applying paragraphs 74 and75 of IAS 1, the grace period provided by the lender is not more than twelve monthsafter the reporting period, and hence the entity would classify such loan as current.18) Given the above, the HKICPA suggests that the IASB clarify the relationship betweenparagraph 72B of the ED and paragraphs 74 and 75 of IAS 1, and which paragraphshould be applied to the scenario provided in paragraph 16 above.Meaning of “substance” in paragraph 72A19) Paragraph 72A of IAS 1 introduces a notion that the right to defer settlement of aliability “must have substance”. A few respondents considered that there is noguidance on the meaning of “substance” in IAS 1 which may lead to a risk of differentinterpretation. We note that the concept of “substance” is not new in the context ofIFRS Standards and several standards (e.g. IAS 32 Financial Instruments:

Presentation and HKFRS 16 Leases) contain explicit requirements to take account ofthe substance of an entity’s rights and obligations. However, to enhance consistentapplication of the proposals, we suggest that the IASB:

i.explain what is meant by a right that has or does not have substance in thecontext of current/non-current classification of a liability, e.g. whether itshould be viewed from a legal perspective; andii.clarify whether the condition of “a change of control” would be considered tohave substance.“Affect” in IAS 1 vs “control” in IAS 3220) A few respondents questioned the differences between the requirements for thecurrent/non-current classification of a liability in IAS 1 and the equity/liabilityclassification in paragraph 25 of IAS 32 as both requirements relate to potential cashoutflows. In IAS 32, a change in control triggers a financial liability classification whenthe entity cannot avoid the occurrence of such event (i.e. the worst case scenario),but then this liability would be classified as non-current if the entity can avoid thatevent occurring in the coming twelve months applying the proposal (i.e. not the worstcase scenario). These respondents noted that paragraph BC20 of the ED states thatPage 7 of 8the meaning of “affect” in paragraph 72C(b) of the ED is not the same as “control” inparagraph 25 of IAS 32, but does not explain why they should be different.21) In light of the above, we suggest the IASB explain clearly the reasons for thedifferences between the requirements in the proposal and IAS 32, as well as how theyare different in the Basis for Conclusions. We also suggest that the IASB clarifywhether the liquidity disclosure for financial liabilities under IFRS 7 FinancialInstruments: Disclosures should follow the “not within the entity’s control” principle orthe “affect” principle in the proposal.Disclosures (paragraph 76ZA(b))

22)

Many respondents raised the following concerns with respect to the proposeddisclosure on future compliance with covenants in paragraph 76ZA(b)(iii) of the ED:

i.The proposed disclosure may not be useful to users of financial statementsbecause a definitive “yes/no” description of whether the covenants wouldbe met after the reporting period could be misleading.ii.The proposed disclosure involves forward-looking information which wouldlikely increase the costs for preparers to prepare, and the practicaldifficulties for auditors to audit, such information.iii.A respondent is also concerned about the legal implication arising from theproposed disclosure. For example, whether it would trigger any legalobligation of an entity if the final outcome is different from that disclosed inthe financial statements (e.g. the entity discloses in the financial statementsthat management expects to comply with the covenants after the reportingperiod but it fails to fulfil the condition subsequent to the reporting period).iv.An investor appreciated the intention of the proposed disclosure butconsidered that the assessment of whether an entity expects to comply withthe conditions after the end of the reporting period is highly subjective andhence, the disclosure may not be useful to users. This respondent alsoconsidered that whether an entity expects to comply with covenants in thefuture might affect the entity’s going-concern and in the case of a listedentity, its share price. Therefore, the relevant disclosure should be set andenforced by regulators, instead of the IASB.23)

On the other hand, a minority of the respondents supported the proposed disclosure.They disagreed with the arguments in paragraph AV5 of the ED for the reason thatrecent IFRS Standards also require the incorporation of forward-looking informationto measurement, e.g. expected credit loss in IFRS 9 Financial Instruments. Arespondent further considered that the argument in paragraph AV5 that users offinancial statements should be capable of assessing the risk that a condition may bebreached based on the proposed disclosures supported by an analysis of financialreports along with additional economic information would not work for certain non-financial covenants, e.g. reaching milestones for developing a generic drug.24)

The HKICPA acknowledges the concerns raised by our respondents in paragraph 22above, in particular, the costs and benefits considerations and the potential legalimplication of pursuing the proposal. In light of this, we recommend the IASB replacethe proposed disclosure in paragraph 76ZA(b)(iii) of the ED with the disclosures ofkey factors which may affect the ability of an entity in complying with the conditionsafter the reporting date. We consider these suggested disclosures would be objectiveand provide more useful information for users of financial statements to make theirown decisions.25)

In addition, we recommend the IASB consider improving liquidity disclosures underPage 8 of 8paragraph B11C-11F of IFRS 7 and defaults and breaches of loan covenants underparagraphs 18-19 of IFRS 7 by requiring additional disclosures of covenants in theabsence of a breach and the associated risks. This would improve the interactionbetween IFRS 7 and IAS 1, and address the concerns stated in paragraph BC21 ofthe ED.Question 2 – Presentation (paragraph 76ZA(a))

26)

We disagree with the proposed separate presentation requirement in paragraph76ZA(a) of the ED. Instead, we agree with the Alternative Views in paragraphs AV3and AV4 of the ED that the disaggregation requirements in paragraph 55 of IAS 1already set out the principles for presenting additional line items in the statement offinancial position when it is relevant to an understanding of an entity’s financialposition. The proposed separate presentation seems to contradict the principle-basednature of IFRS Standards.27)

We support identifying non-current liabilities for which the entity’s right to defersettlement for at least twelve months after the reporting period subject to compliancewith specified conditions within twelve months after the reporting period throughdisclosures in the notes to the financial statements. We also consider that providingthe proposed disclosures in paragraph 76ZA(b)(i) and (ii) of the ED, together with ourrecommendations in paragraphs 24 and 25 above, would be sufficient for users toidentify and assess the risk of those liabilities. Hence, we suggest that the IASBremove the separate presentation requirements in paragraph 76ZA(a) of the ED.Question 3 – Other aspects of the proposalsTransition and effective date28)

The HKICPA has no major comments on the retrospective application and thedeferral of the effective date of the amendments to IAS 1.~ End ~