12.2 Classification
When classifying liabilities, we need to assess two conditions: is the liability financial or non-financial, and is the liability current or non-current.
Financial or Non-Financial
IAS 32.11 defines one type of financial liability to be a contractual obligation:
- to deliver cash or another financial asset to another entity; or
- to exchange financial assets or financial liabilities with another entity under conditions that are potentially unfavourable to the entity (CPA Canada, 2016, IAS 32.11).
A key feature of this definition is that the obligation is created by a contract. This means that there needs to be some type of business relationship between the parties. Liabilities that are created by laws, such as taxation liabilities, do not meet this definition. Other types of non-financial liabilities include unearned revenues, warranty obligations, and customer loyalty programs. These are non-financial because the obligation is to deliver goods or services in the future, rather than cash.
Financial liabilities will normally be initially measured at their fair value, and many will be subsequently measured at their amortized cost. (Note: this definition will be expanded in a later chapter covering complex financial instruments.) Non-financial liabilities are normally measured at the amount the entity would pay to settle the obligation, or to transfer it to a third party. This definition presumes that the entity would act in rational manner (i.e., the presumed settlement is arm’s length, non-distressed, and orderly). The determination of this amount will be discussed in more detail later in this chapter.
Current or Non-Current
One of the essential characteristics of a classified balance sheet is the distinction between current and non-current items. This distinction is useful to readers of the financial statements as it helps them to understand the demands on the entity’s resources and the potential timing of future cash flows. This information may have an effect on the readers’ decisions, so an understanding of this classification is important.
IAS 1 requires the use of current and non-current classifications for both assets and liabilities, unless a presentation in order of liquidity is reliable and more relevant. IAS 1.69 defines liability as current when:
- The entity expects to settle the liability in its normal operating cycle.
- The entity holds the liability primarily for the purpose of trading.
- The liability is due to be settled within 12 months after the reporting period.
- The entity does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting period. Terms of a liability that could, at the option of the counterparty, result in its settlement by the issue of equity instruments do not affect its classification. (CPA Canada, 2016, IAS 1.69).
One of the key components of this definition is the operating cycle. A company’s operating cycle is the time from the acquisition of raw materials, goods, and other services for processing, to the time when cash is collected from the sale of finished goods and services. This cycle can vary greatly between industries. For example, a grocery store, which sells perishable food products, would have a very short operating cycle, perhaps only a few weeks, while a shipbuilding company may take several years to complete and sell a single vessel. For those liabilities that are part of the company’s working capital, the operating cycle would be the primary determinant of the current classification, even if settlement occurs more than 12 months after the year-end. For other liabilities that are not part of the company’s working capital, the other elements of the definition would be applied. In some cases, the operating cycle may not be obvious or well defined. In these cases, the operating cycle would normally be assumed to be 12 months. Keep the criteria for current classification in mind as we examine more detailed examples of these current liabilities.
