Many debt agreements contain covenants that the reporting entity must adhere to throughout the life of the agreement. Covenants are negotiated between a reporting entity and its lenders and may vary from agreement to agreement. Financial ratio covenants, which require the reporting entity to maintain various financial ratios, are included in nearly every debt agreement. A breach of a covenant triggers an event of default which may allow the lender to demand repayment (i.e., it becomes puttable).
When a covenant violation causes long-term debt to become puttable, the debt and related debt discount, premium, or issuance costs should be reclassified as current liabilities; however, we do not believe debt issuance costs, discounts, or premiums should be automatically amortized in full upon the reclassification of a long-term liability to a current liability.
indicates that the classification of the debt (and related contra accounts) does not have to be the same as the time frame used to amortize debt issuance costs, discount, and premium. A reporting entity should evaluate its specific facts and circumstances, including the following points, to determine whether it should amortize its debt issuance costs, discounts, or premiums in full.
- The nature and existence of active negotiations between the lender and the reporting entity to secure a waiver, or restructure the debt
- The financial condition of the reporting entity, and the likelihood that the lender will demand repayment rather than grant a waiver
- Its history of obtaining prior waivers, if any, from the lenders
- Execution of a written forbearance agreement and whether, during the forbearance period, the parties have agreed to negotiate to restructure the debt
If the preponderance of the evidence at the financial statement issuance date leads a reporting entity to conclude that there is a reasonable likelihood that it will be able to successfully negotiate a waiver with the lender, then amortization of debt issuance costs, discounts, and premiums should continue as before the violation, with adequate disclosure of the circumstances.
If a lender waives a covenant violation for no consideration (either explicit or implicit), no accounting is required under ASC 470-50-40
because there is no change in cash flows. A payment (of cash or other instruments) made to a lender to effect a waiver of a covenant violation is considered a modification of the terms of the debt instrument. When such a payment is made, the reporting entity should analyze the modification using the debt modification guidance discussed in FG 3.4
Question FG 1-3 asks whether a covenant violation or debt modification has an effect on a reporting entity’s amortization of debt issuance costs, discounts, or premiums.
Question FG 1-3
A reporting entity violates a covenant in its puttable debt instrument. The reporting entity restructures its debt agreement and obtains a debt covenant waiver. As a result of the waiver, the debt is classified as noncurrent in its period end financial statements. As part of the restructuring, the date the put option is first exercisable is accelerated; however, the contractual term remains the same as the original debt instrument.
Does the covenant violation or debt modification have an effect on the reporting entity’s amortization of debt issuance costs, discounts, or premiums?
Maybe. The reporting entity should first apply the guidance in ASC 470-50-40-10
to determine whether the changes to the instrument should be accounted for as a modification or extinguishment. See FG 3.4
for information on accounting for a modification of a term loan or debt security. If the debt instrument is modified, the reporting entity should continue to account for the debt issuance costs, discounts or premiums based on its accounting policy election as of the original issue date.
If the reporting entity has elected an amortization period from the issuance date to the date the put is first exercisable, then, as of the modification date, any unamortized debt issuance costs, discounts, or premiums should be amortized to the new put date. If the reporting entity has elected an amortization period over the contractual life of the debt instrument, it should continue this policy.
If the modification is accounted for as an extinguishment, then any unamortized debt issuance costs, discounts, or premiums should be expensed as part of the extinguishment gain or loss.
If the reporting entity had not obtained a waiver as of the financial statement issuance date, and the preponderance of the evidence lead to a conclusion that it would not be able to negotiate a waiver, any debt issuance costs, discounts, or premiums would have been expensed as of the date that the debt became puttable (i.e., the covenant violation date), because the debt was, and would continue to be, demand debt notwithstanding any restructuring.