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2.5 Debt (pre-bankruptcy)
Publication date: 31 Oct 2022
us Bankruptcy & liquidation guide
Given the deteriorating financial conditions usually associated with companies moving toward bankruptcy, companies might violate covenants (financial and nonfinancial) in existing debt agreements. When a covenant violation is triggered, the debt may become due on demand, or callable, by the lender. Under the guidance in ASC 470, Debt, these obligations may need to be classified as current unless the lender has waived or subsequently lost the right to demand repayment for more than a year (or operating cycle) from the balance sheet date. In other instances, when the long-term obligation agreement contains a grace period provision, the obligation may need to be classified as current unless it is probable that the debtor will cure the violation within the grace period, thus preventing the obligation from becoming callable.
Companies that have violated a covenant but obtained a waiver at period-end should consider whether they will continue to meet the covenant in future periods. If a future violation is probable, the debt should be classified as a current obligation. If compliance with applicable covenants is probable for the next 12 months, the debt obligation should continue to be classified as noncurrent.
Companies should be mindful of the disclosure requirements associated with debt covenant violations and waivers, including specific disclosure requirements for SEC registrants pursuant to Rule 4-08(c) of Regulation S-X.
2.5.1 Debt issuance costs (pre-bankruptcy)
Like debt premiums and discounts, debt issuance costs should be reported as an adjustment to the carrying amount of the related liability. Debt issuance costs are usually amortized to interest expense over the contractual or expected term of the debt in accordance with a reporting entity's accounting policy. See FG 1.2 for information on issuance costs associated with term debt. Costs associated with entering into a revolving line of credit or a revolving debt arrangement are recorded separately on the balance sheet (as opposed to the contra-liability presentation used for issuance costs for term debt) and amortized on a straight-line basis over the contractual term of the arrangement (i.e., the access period). See FG 1.3 for information on the accounting for issuance costs associated with revolving lines of credit.
When debt is reclassified to short term because of a covenant violation, questions may arise as to the need to write-off the unamortized debt issuance costs as the covenant violation may result in the shortening of the related life of the debt. Factors to consider when determining whether unamortized debt issuance costs should be written off to expense include:
- Nature and existence of active negotiations between the lender and debtor to secure a waiver or restructure the debt
- Financial condition of the debtor and how likely the lender would be to call the debt and demand repayment rather than grant a waiver or forebear
- History of obtaining prior waivers, if any, from the lender
- Execution of a written forbearance agreement and whether during the forbearance period the parties have agreed to negotiate to restructure the debt
If the debt will not be renegotiated or a waiver will not be obtained, the debt issuance costs should be written off because the debt has effectively become demand debt.
On the other hand, if there is a reasonable likelihood that the debt will be renegotiated or a waiver obtained and the debt will ultimately maintain its long-term nature, the amortization of debt issuance costs should continue as before the violation with adequate disclosure. The unamortized debt issuance costs should continue to be reported as an adjustment to the carrying amount of the related liability if the related debt is classified as short-term. The reporting entity should also disclose the balance of unamortized debt issuance costs that may be required to be written off in the event that a waiver or restructuring of terms cannot be negotiated and the debt is either redeemed or otherwise extinguished.
See FG 1.2.3.3 for considerations related to the amortization of debt issuance costs and debt discounts and premiums when a reporting entity seeks to restructure its outstanding debt obligations.
2.5.2 Debt extinguishments and modifications (pre-bankruptcy)
Companies often consider a variety of potential transactions with creditors or security holders to enhance liquidity. The transactions may involve cash settlement, an issuance of equity for debt, an exchange of debt, or modification of debt terms.
When debt instruments are either exchanged or modified, the debtor must first determine whether the exchange or modification meets certain criteria to be considered a "troubled debt restructuring" following the guidance in ASC 470-50, Debt—Modifications and Extinguishments. These criteria include assessing whether the debtor is experiencing financial difficulty and whether the creditor has granted a concession. If the criteria are met, a gain is recognized, but only to the extent that the gross cash flows of a new or modified debt instrument are less than the carrying amount of the old debt instrument. If the gross cash flows exceed the carrying amount of the old debt, no gain is recorded and a new effective interest rate is established based on the carrying amount of the debt and the revised cash flows.
If an exchange or modification of an instrument is not a troubled debt restructuring, the debtor must still determine whether the transaction meets the criteria to be considered an extinguishment. If the modified or new debt instrument has substantially different terms from the old debt instrument, an extinguishment is recognized. If the exchange is considered a modification, the effects are generally reported prospectively utilizing a new effective interest rate determined based on the carrying amount of the original debt and the revised cash flows. Interest expense is recognized using the new effective interest rate.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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