As discussed in ASC 470-10-55-1
, there is a high threshold to achieve noncurrent classification for debt that is otherwise current through the issuance of a financing agreement. Long-term financing agreements that contain subjective acceleration, material adverse change, or material adverse effect clauses are specifically prohibited from being used to support reclassification of short-term obligations from current to noncurrent. This is because the parties to the financing agreement may interpret SAC, MAC, MAE, and other nonobjectively verifiable clauses differently.
Due to their subjective nature, such clauses may result in the lender refusing to allow the reporting entity to refinance its short-term obligations. Therefore, this would undermine the reporting entity's assertion that it has the "ability" to refinance the current obligation into long-term, noncurrent debt. However, an agreement that objectively defines an "adverse change" would be acceptable for purposes of demonstrating ability to refinance (or continuing to finance). The "adverse change" definition should include specific, quantifiable criteria, such as minimum working capital requirements, maximum dollar or percentage decrease in sales or earnings, or other objective measurements. If such criteria are present, noncurrent classification would be acceptable, provided the other required conditions are met.
It may be difficult to meet the objectivity standard in some cases. For example, language may appear to be objective but require the use of subjective assumptions—for example, forward-looking criteria that require the use of projections, which are subjective by their nature. Such a provision would not be considered an objectively-defined "adverse change." Reporting entities should ensure that language included in agreements to provide a more precise definition of "adverse change" is truly objective, and not simply less subjective than the original language.
The following subsections discuss certain situations that may impact a reporting entity's ability to meet the requirements of ASC 470-10-45-14
(b) with regard to subjective clauses.
Upfront representations and warranties
Certain clauses in financing agreements involve the reporting entity representing to the lender that, between the date of the most recent audited financial statements and the date of signing the financing agreement, there have been no MACs or MAEs. If a financing agreement requires a borrower to make such a representation each time it requests funding under the agreement, this financing agreement would not evidence an ability to borrow on a long-term basis.
On the other hand, if a date-limited representation is required only at the time of, and as a condition of, entering into the financing agreement, the borrower and the lender have the ability to evaluate whether or not a material event or a material change actually occurred prior to execution of the financing agreement. If the lender determines that such an event has not occurred, the financing agreement is executed and, thereafter, the agreement is substantively not cancelable. Therefore, the borrower is able to demonstrate its intent to refinance on a long-term basis.
The borrower needs to determine whether the MAE or MAC was a date-limited representation required only at the time of, and as a condition of, entering into the financing agreement to achieve noncurrent classification. Specifically, such representation clauses need to (1) include date range limitations for the period from the most recent audited financial statements to the date of signing the financing agreement, (2) be represented and warranted only at the time the financing agreement was entered into as a condition to execution of the agreement, and (3) not be subject to re-representation requirements in the future, such as at the time of a future draw-down request.
Dual-trigger clause qualifying language
Dual-trigger clauses—which trigger a MAE or MAC only after a sufficiently-objective clause is not met (i.e., if the objectively verifiable portion is met, the second portion would never be operable)—are also acceptable for purposes of asserting ability to refinance long-term.
A dual-trigger clause may take the form of a management representation required at the time of draw down, such as:
"Since the date of our last representation to you, there have been no lawsuits filed that have had or are expected to have a material adverse effect on our financial position or results of operations."
Whether a lawsuit has been filed is an objective matter. If no lawsuits have been filed during the representation period, there is no basis for the lender to refuse to fund the draw-down request. This subjective qualifier becomes operative only after the objective event occurs. In the absence of the occurrence of the objective event, there would be no event of default that allows the lender to refuse to honor a draw-down request.
Notwithstanding the above, there have been instances when a SAC, MAC, or MAE included in unrelated debt obligations could cause a cross-default of the long-term financing agreement that the reporting entity would use to support its "ability" assertion under ASC 470-10-45-14
. If there is such a clause, the conditions of ASC 470-10-45-14
would not be met and the debt should remain classified as current.
Example FSP 12-5 demonstrates the classification of debt when the reporting entity seeks to refinance but the new agreement contains a SAC clause.
EXAMPLE FSP 12-5
Classification of short-term debt based on a financing agreement containing a SAC clause
At the balance sheet date, FSP Corp has a $10 million borrowing with a contractual maturity of less than 12 months. FSP Corp also has a $100 million revolving credit agreement that is unused and that has a remaining term of 5 years. Borrowings under the revolver may be long-term, as the borrower is permitted to choose any debt term from one to five years. However, future borrowings under the revolving credit agreement are subject to a SAC.
How should FSP Corp classify the $10 million borrowing at the balance sheet date?
Even if the borrower has the intent to use the revolver to refinance its short-term obligation, it must classify the $10 million outstanding debt as part of current liabilities. This is because the SAC undermines the borrower's ability to refinance the short-term debt on a long-term basis.