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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 would 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. This would include disclosure in the notes of the financial statements about the circumstances and amounts regarding any default of principal, interest, sinking fund or redemption provisions, or breach of contract that has not been subsequently cured. There are specific disclosure requirements for SEC registrants. Rule 4-08(c) of Regulation S-X requires a registrant to disclose the following:

Excerpt from S-X 4-08(c)

The facts and amounts concerning any default in principal, interest, sinking fund, or redemption provisions with respect to any issue of securities or credit agreements, or any breach of covenant of a related indenture or agreement, which default or breach existed at the date of the most recent balance sheet being filed and which has not been subsequently cured, shall be stated in the notes to the financial statements. If a default or breach exists but acceleration of the obligation has been waived for a stated period of time beyond the date of the most recent balance sheet date being filed, state the amount of the obligation and the period of the waiver.

2.4.1  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 costs incurred in exchange for access to capital. That is, the fees are paid regardless of whether the funds are ever drawn down. As such, the costs meet the definition of an asset and should be recorded as such 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 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.

2.4.2 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.
This topic is discussed further in ASC 470-50, FG 3.3, and FG 3.4.

2.4.3 Ongoing standard setting (pre-bankruptcy)

The FASB has issued a proposed ASU, Debt (Topic 470), Simplifying the Classification of Debt in a Classified Balance Sheet (Current versus Noncurrent), which introduces a principle for determining the classification of debt at the balance sheet date. Financial statement preparers and other users of this publication are therefore encouraged to monitor the status of the project, and if finalized, evaluate the effective date of the new guidance and the implications on financial statements.

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