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Accurate debt classification is important for reasons beyond simply complying with US GAAP. First, it can impact a reporting entity's ability to raise funds. Debt classification is typically a key component in calculating ratios that prospective investors and lenders (creditors) use to gauge a reporting entity's liquidity and credit risk. In addition, balance sheet classification can impact contractual covenant compliance. Covenants may require a reporting entity to calculate certain financial ratios that are directly affected by debt classification. One such example is working capital, which is calculated as the difference between current assets and current liabilities.
There are many nuances to consider when classifying debt, and often, a debt agreement can include terms that may yield unanticipated classification answers. These terms include:
  • Call and put options
  • Subjective acceleration clauses
  • Debt covenants
ASC 470-10-20 defines a long-term obligation.

Definition from ASC 470-10-20

Long-term obligations: Long term obligations are those scheduled to mature beyond one year (or the operating cycle, if applicable) from the date of an entity's balance sheet.

As a general rule, if the debt is a long-term obligation, it is ordinarily presented as noncurrent. Conversely, if the debt is a short-term obligation (either by its original terms or because of a non-waived covenant violation), the debt is generally presented as current. Specific classification considerations are discussed in the following sections.

12.3.1 Callable debt

Debt agreements may contain call options that give the borrower (debtor) the option to prepay the debt prior to its maturity date. The terms of these options may vary. For example, some agreements allow for prepayment of debt at any time while others allow prepayment only upon specific contingent events.
Typically, the existence of a call option in a debt agreement should not impact classification because call options are at the borrower's discretion. The call options do not create a requirement to pay off the debt at a certain date, but rather they give the borrower a choice to pay off the debt prior to maturity.
In addition, exercising a call right or announcing the intent to exercise a call right after the balance sheet date but prior to issuance of the financial statements generally does not affect classification.

12.3.1.1 Exercising a call right prior to the balance sheet date

If the reporting entity announces a plan to exercise a call right prior to the balance sheet date, the debt should be classified as current if that announcement creates a legally-binding obligation or an irrevocable commitment to redeem the debt within one year from the balance sheet date (or the operating cycle, if longer).

12.3.1.2 Exercising a call right after the balance sheet date

The announcement and execution of a call option after the balance sheet date but before the financial statements are issued has no effect on balance sheet classification. However, the reporting entity should disclose the exercise of the call option subsequent to the balance sheet date as a nonrecognized subsequent event. See FSP 28.6.3.2 for further discussion.

12.3.2 Puttable debt

Debt agreements may contain put options that allow the lender to demand repayment prior to maturity. Puttable debt is also sometimes referred to as callable debt because debt that is puttable to the borrower/issuer is equivalent to debt that is callable by the lender. Regardless of terminology, this feature provides the lender with the right to deliver its loan back to the borrower/issuer at a fixed price that meets the more general description of a put option.
Some put options can be exercised at any time, while others are contingently exercisable upon the occurrence of specific events. Debt classification for these types of instruments requires consideration of the terms in the debt agreement.

12.3.2.1 Due-on-demand loan agreements

Debt that is puttable by the lender based on conditions that existed at the balance sheet date is considered a due-on-demand loan. Due-on-demand loan agreements provide the lender with a right to demand repayment at any time at its discretion. The due-on-demand language can vary by agreement. Some typical examples include the following:
  • The term note matures in monthly installments or on demand, whichever is earlier
  • Principal and interest are due on demand or annually
As discussed in ASC 470-10-45-10, obligations that, by their terms, are due on demand or will be due on demand within one year (or the operating cycle, if longer) from the balance sheet date—even if liquidation is not expected within that period—are required to be classified as current liabilities.

12.3.2.2 Subjective acceleration clauses

Long-term financing agreements may contain subjective acceleration clauses (SAC), in which the lender may refuse to continue to lend if the borrower experiences an adverse change. These clauses are typically referred to as material adverse change (MAC) or material adverse effect (MAE) clauses.
Unlike a demand provision, a SAC typically requires a covenant violation or default event to occur before it can be invoked. The ASC Master Glossary defines a subjective acceleration clause.

Definition from ASC Master Glossary

Subjective Acceleration Clause: A subjective acceleration clause is a provision in a debt agreement that states that the creditor may accelerate the scheduled maturities of the obligation under conditions that are not objectively determinable (for example, if the debtor fails to maintain satisfactory operations or if a material adverse change occurs).

As discussed in ASC 470-10-45-2, the likelihood of the due date being accelerated determines the classification of debt with a SAC.
  • If acceleration of the due date is probable (e.g., the reporting entity has recurring losses or liquidity problems), the long-term debt subject to a SAC should be classified as a current liability. For purposes of this determination, reporting entities should use the definition of "probable" in ASC 450, Contingencies.
  • If acceleration of the due date is judged reasonably possible, disclosure of the existence of a SAC clause is generally sufficient. The debt may be classified as noncurrent.
  • If the acceleration of the due date is deemed remote, neither reclassification nor disclosure is required.
Example FSP 12-1 illustrates the accounting treatment for debt due on demand and debt with a subjective acceleration clause.
EXAMPLE FSP 12-1
Demand provision versus subjective acceleration clause
As of December 31, 20X1, FSP Corp, a reporting entity whose financial condition is strong, has two outstanding loans, Loan D and Loan S. Both loans have a stated maturity date beyond December 31, 20X2 (one year from the balance sheet date).
Loan D contains a demand provision that allows the lender to put the debt to FSP Corp at any time.
Loan S contains a SAC that would allow the lender to put the debt to FSP Corp if a material adverse change in FSP Corp's financial condition occurs.
The lender historically has not accelerated due dates of loans containing similar clauses.
How should FSP Corp classify Loan D and Loan S on its balance sheet as of December 31, 20X1?
Analysis
Loan D should be classified as current. A demand provision requires current liability classification even if liquidation is not expected within the period.
Loan S should be classified as noncurrent (as long as there are no covenant violations). A SAC does not require classification of the debt as current if the likelihood of acceleration of the due date (the lender's exercise of the SAC) is not probable. Because the likelihood of acceleration of the due date is remote, no disclosure is required either.

12.3.2.3 Contingently puttable debt

Debt agreements may contain clauses that make the debt puttable upon certain contingent events. At each reporting period, the reporting entity should assess whether a contingent event has occurred as of the balance sheet date that makes the debt obligation puttable. If so, current classification is required. See FSP 12.12 and FSP 23.4 for disclosure considerations.

12.3.3 Classification of debt with a covenant violation

Many debt agreements include covenants on the borrower for the life of the agreement. Breach of a covenant triggers an event of default, which may lead to an increase in the interest rate or a potential demand for repayment (i.e., the debt becomes due).
Figure FSP 12-1 summarizes various covenant violation scenarios and their related impact on classification. It also references the section in this chapter where each scenario is discussed in detail.
Figure FSP 12-1
Debt classification resulting from covenant violations at the balance sheet date
Covenant violation scenario
Classification
Section
(1) Violation; no waiver; no grace period
Current
(2) Violation; no waiver; grace period
— It is probable the violation will be cured
Noncurrent
— It is not probable the violation will be cured
Current
(3) Violation; waiver or modification obtained after the balance sheet date
— Covenant not required to be met within one year from the balance sheet date
Noncurrent
— It is reasonably possible the covenant will be met at subsequent testing dates within one year from the balance sheet date
Noncurrent
— It is probable the covenant will not be met at subsequent testing dates within one year from the balance sheet date
Current
(4) Violation avoided through modification made before the balance sheet date
— It is reasonably possible the covenant will be met at subsequent testing dates within one year from the balance sheet date
Noncurrent
— It is probable the covenant will not be met at subsequent testing dates within one year from the balance sheet date
Current
(5) Violation occurring or anticipated after the balance sheet date
Noncurrent
See FSP 12.9 for a discussion of the balance sheet classification of unamortized debt issuance costs and FSP 12.8 for discussion of the balance sheet classification of debt discount/premium associated with debt that is reclassified to current due to a covenant violation.

12.3.3.1 Covenant violation - no waiver obtained

If a borrower violates a debt covenant that does not include a specified grace period, the obligation becomes puttable by the lender (i.e., due-on-demand debt). As discussed in FSP 12.3.2.1, long-term obligations that are, or will be, puttable by the lender are required to be classified as current liabilities.

12.3.3.2 Covenant violation - no waiver obtained and a grace period

If a covenant violation has occurred at the balance sheet date and there is a grace period in effect, these puttable obligations should be classified as current. However, if it is probable the violation will be cured within that period, ASC 470-10-45-11(b) indicates that the obligation can be classified as noncurrent.

12.3.3.3 Covenant violation - waiver or modification

Classification of debt that has a covenant violation waived or modified after the balance sheet date depends on the manner in which the waiver or modification was provided.
Same or more restrictive covenant is required to be met going forward
Frequently, a covenant violation occurs at the balance sheet date and the lender requires the borrower to meet the same covenant, or a more restrictive covenant, in the next 12 months. ASC 470-10-55-2 through ASC 470-10-55-6 indicates that the obligation should be classified as a noncurrent liability at the balance sheet date if a waiver is obtained, unless the borrower concludes that the chance of meeting the same or more restrictive covenants at subsequent compliance measurement dates within the next year is remote (i.e., it is probable the borrower will violate the future covenant). As long as the borrower can conclude that it is at least reasonably possible that it will be able to meet the covenant when required, the debt should remain classified as noncurrent.
Example FSP 12-2 illustrates the classification of debt with a waiver of a covenant violation but the lender requires the borrower to meet the same covenant going forward.
EXAMPLE FSP 12-2
Classification of debt with waiver of a covenant violation at the balance sheet date, but the same covenant needs to be met going forward
FSP Corp, the borrower, is not in compliance with its working capital covenant at December 31, 20X1.
The lender waives its right to put the debt based on the December 20X1 violation. However, FSP Corp is required to meet the same working capital covenant on March 31, 20X2, and it is probable that it will not do so.
How should FSP Corp classify the debt in the December 31, 20X1 balance sheet?
Analysis
FSP Corp should classify the debt as a current liability in its December 31, 20X1 balance sheet. Although it obtained a waiver for the violation occurring at the balance sheet date, it is probable it will not meet that covenant in the next period, triggering current classification.

Same or more restrictive covenant is not required to be met going forward
If a covenant violation has occurred at the balance sheet date, the lender may not require the borrower to meet the same covenant, or a more restrictive covenant, in the next 12 months (although this circumstance is unusual). ASC 470-10-45-11(a) indicates that the associated obligations should be classified as current unless one of the following conditions exists:
  • The lender has waived the right to demand repayment for more than a year (or an operating cycle, if longer) from the balance sheet date

    If the obligation is puttable because of violations of certain provisions of the debt agreement, the lender needs to waive its right with regard to only those specific violations.
  • The lender has subsequently lost the right to demand repayment for more than a year (or an operating cycle, if longer) from the balance sheet date

    For example, if the borrower has cured the violation after the balance sheet date and the obligation is not puttable at the time the financial statements are issued, the lender has lost the right to demand repayment.

12.3.3.4 Covenant violation avoided through a loan modification

A borrower may determine in advance of the balance sheet date that it will not be able to meet certain covenants. The borrower may seek to modify the debt agreement in advance so it will be compliant at the balance sheet date. In this fact pattern, the modification is in substance a waiver, except that it is obtained prior to the actual violation (instead of after, as a waiver would be).
ASC 470-10-55-4(d) provides guidance for when a covenant would have been violated at the balance sheet date absent a modification of the debt agreement before the balance sheet date, and for which violation is probable at the subsequent compliance date after the balance sheet date. It requires current classification of the debt, unless the provisions of ASC 470-10-45-13 through ASC 470-10-45-20 for refinancing short-term debt (discussed in FSP 12.3.4) are met, in which case the debt may be classified as noncurrent.
Example FSP 12-3 illustrates the classification of debt when a covenant violation is avoided through a loan modification.
EXAMPLE FSP 12-3
Classification of debt with a covenant violation avoided at the balance sheet date through a loan modification
FSP Corp, the borrower, does not expect to be in compliance with its working capital covenant at December 31, 20X1.
On December 15, 20X1, FSP Corp negotiates a modification to the debt agreement to eliminate this covenant until June 29, 20X2.
FSP Corp is required to meet the same working capital covenant on June 30, 20X2, and it is probable that it will not do so.
How should FSP Corp classify the debt in the December 31, 20X1 balance sheet?
Analysis
FSP Corp should classify the debt as a current liability at the balance sheet date because it would have violated the covenant at December 31, 20X1 had it not entered into the loan modification, and because it is probable it will not meet that covenant within the next year.

12.3.3.5 Covenant violation after the balance sheet date

ASC 470-10-55-4(a) through ASC 470-10-55-4(c) address classification when a covenant violation is probable after the balance sheet date, but no violation existed at the balance sheet date. In those instances, noncurrent classification would be appropriate (assuming all other conditions for noncurrent classification have been met). This is true regardless of whether the violation occurs after the balance sheet date but before the financial statements are issued, or if the violation is anticipated to occur in the next year. In these situations, ASC 470-10-55-5 requires the borrower to disclose the adverse consequences of its probable failure to satisfy future covenants.
The key factor in understanding this conclusion is that compliance with debt covenants is determined at the balance sheet date. The guidance in ASC 470-10-55-2 through ASC 470-10-55-6 is similar to subsequent events guidance—indicating that "unless the facts and circumstances would indicate otherwise," the borrower should classify the obligation as noncurrent in these circumstances.
We believe the wording "unless the facts and circumstances would indicate otherwise" was added to the guidance to permit current classification in the limited circumstances when the reporting entity concluded this was a more appropriate presentation.
Example FSP 12-4 illustrates the classification of debt with a covenant violation after the balance sheet date.
EXAMPLE FSP 12-4
Classification of debt with a covenant violation after the balance sheet date
FSP Corp, the borrower, receives an audit opinion in February 20X2 on its December 31, 20X1 financial statements with an emphasis of a matter paragraph related to its ability to continue as a going concern. FSP Corp's debt agreement states that receiving an audit opinion with a going concern issue is an event of default. Therefore, this covenant was violated in the following year when the going concern opinion was issued.
How should FSP Corp classify the debt in the December 31, 20X1 balance sheet?
Analysis
It depends.
We believe if the debt agreement contains a SAC, it should be classified as current at December 31, 20X1. Consistent with the guidance discussed in FSP 12.3.2.2, acceleration of the due date is probable due to the going concern opinion.
If there is no SAC, FSP Corp should apply judgment. Technically, the covenant violation occurred after the balance sheet date, so a literal read of the guidance would indicate noncurrent classification. However, based on the facts and circumstances of this example (i.e., the going concern issue), FSP Corp might deem it more appropriate to classify the debt as current.

12.3.4 Refinancing short-term debt

ASC 470-10-45-14 indicates that short-term obligations should be reclassified as noncurrent at the balance sheet date if the borrower has both the intent and ability to refinance the short-term obligation on a long-term basis. ASC 470-10-45-14(a) indicates that a borrower can demonstrate this intent and ability by actually refinancing the short-term obligation before the financial statements are issued in one of the following ways:
  • Issuing a long-term obligation
  • Issuing an equity security
Additionally, in lieu of actually issuing a new long-term obligation, ASC 470-10-45-14(b) indicates that a borrower can evidence its ability to refinance on a long-term basis by entering into a financing agreement before the financial statements are issued. The financing agreement would need to satisfy all of the following conditions:
  • It does not expire within one year from the balance sheet date.
  • It is only cancelable by the lender based on objective measures.
  • No violation of any provision in the agreement exists at the balance sheet date or balance sheet issuance date, or if a violation does exist, the reporting entity has obtained a waiver
  • The lender is expected to be financially capable of honoring the financing agreement.

12.3.4.1 Refinancing short-term debt — subjective acceleration clause

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.
Cross-default clauses
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?
Analysis
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.

12.3.4.2 Use of working capital to refinance debt

ASC 470-10-45-15 indicates that a short-term obligation should be included in current liabilities if it is repaid after the balance sheet date, and is subsequently replaced or replenished by long-term debt before the balance sheet is issued. The FASB noted that repayment of a short-term obligation before funds are obtained through a long-term financing requires the use of current assets and, as such, the short-term obligation cannot be excluded from current liabilities at the balance sheet date. Specifically, as illustrated in the example in ASC 470-10-55-33 through ASC 470-10-55-36, the repayment of commercial paper using working capital after the balance sheet date, followed by a borrowing under a long-term debt arrangement to replenish the working capital prior to the financial statement issuance date, does not meet the intent requirement for refinancing a short-term borrowing on a long-term basis.

12.3.4.3 Inability to refinance debt with parent commitment

Occasionally a borrower may obtain a long-term commitment from its parent (i.e., a parent support letter) as evidence of its intent and ability to refinance a short-term obligation on a long-term basis. Such agreements need to be reviewed carefully. This is because the parent controls the subsidiary and is a related party. If the agreement can be cancelled at any time or there is no deterrent to prevent the parent from cancelling the agreement, the agreement would not meet the provisions of ASC 470-10-45-14(b)(1) and the debt therefore could not be presented as noncurrent.

12.3.4.4 Refinancing with successive short-term borrowings

A short-term obligation that will be refinanced with successive short-term obligations may be classified as noncurrent as long as the cumulative period covered by the financing agreement is uninterrupted and extends beyond one year. This would include short-term borrowings under revolving credit agreements that permit either continuous replacement with successive short-term borrowings for more than a year or conversion to term loans extending beyond a year at the reporting entity's option. However, as discussed in ASC 470-10-45-21, these borrowings can only be classified as noncurrent if the borrower intends to utilize those provisions and meets the criteria for refinancing the short-term debt on a long-term basis included in ASC 470-10-45-14 (b).
The rollover provisions should be included in the terms of the debt obligation; classification as noncurrent cannot be based solely on management's intent. For example, short-term debt in the form of commercial paper should be supported by a contractually long-term financing arrangement, such as a revolving credit agreement with sufficient unused borrowing capacity to support the ability to refinance the commercial paper. However, any SACs, MACs, or MAEs in the refinancing agreements would cause the reporting entity to fail to meet the requirements to assert its ability to refinance its short-term debt on a long-term basis.
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