FASB Wants to Streamline Rules for Classifying Debt

The sprawling machinery of detailed rules in Generally Accepted Accounting Principles on debt classifications may be getting an overhaul.

The Financial Accounting Standards Board has announced its intention to take a fresh look at how to reduce the cost and complexity associated with classifying debt by replacing “fact-pattern specific guidance in GAAP with a principle.” While preparers may welcome the potential simplification, it could come with a catch: potential limitations on what counts as long-term debt.

FASB wants to tell preparers to never mind the prescriptive rules that built up over generations of the financial sector’s engineering of transactions, which has been met with continual standard-setting responses to ever more tedious arrangements. Just look at the contractual terms of a debt arrangement along with your compliance with debt covenants and determine for yourself: Is it “current” or “non-current” debt? With no specific proposal yet on the table, FASB’s timeline for simplifying debt classifications is not clear.

The difference between current and non-current debt is an important distinction on the balance sheet. Current debt, or short-term debt, are funds the lender expects to be repaid in the next 12 months or the next operating cycle if that’s longer than 12 months, says Adam Brown, a partner with BDO USA. Non-current, or long-term debt, suggests the company has more time to pay it off. “People are interested in whether or not it looks like you can meet your obligations, particularly those coming due sooner rather than later,” he says.

Diana Gilbert, senior consultant at accounting and financial consulting firm RoseRyan, says debt classifications help users of financial statements understand how a company can expect to manage its resources. “If the debt is coming due and it’s going to suck up all your current cash or current assets, it’s going to affect your liquidity and your ability to meet other obligations,” she says. “If you have debt that isn’t due for a long time, it’s going to be funded by operations over a long time, so it’s less burdensome.”

“People are interested in whether or not it looks like you can meet your obligations, particularly those coming due sooner rather than later.”
Adam Brown, Partner, BDO USA

Though it might sound simple enough to figure out if debt is due in the next 12 months or not, the determination can be anything but straightforward. “The current standards are written to address several specific situations,” says Brown. “It can be difficult to figure out which set of rules you are in. Hopefully the board can develop a single set of principles that covers them all.”

The Long and Short of It

Long-term loan agreements, for example, can contain provisions known as “subjective acceleration,” “material adverse change,” or “material adverse event” clauses that allow a lender to call in the loan immediately. The bank may not like to hear news of recurring loses, debt covenant violations, or other signs that the company is in trouble. It may want to be paid immediately before the situation worsens.

Such subjective clauses in a long-term arrangement can prevent a company from classifying a loan as long term. “The standards have all kinds of specific examples where in this situation, you call it long term, and in this situation, you call it short term,” says Gilbert.

Perhaps the greatest area of complexity, says Edward Hackert, a partner with Marcum, is in “hybrid” contracts, such as debt with conversion options, or contracts that contain elements of debt and equity. “Sometimes some of these rules are somewhat subjective,” he says.

From the standpoint of simplification, FASB’s constituents are likely to welcome some streamlining of rules, says Mark Scoles, a partner with Grant Thornton. “In some cases it looks like the overarching guidance should be simple,” he says. “But then you get into the details of a specific arrangement, and you really have to know ahead of time what you have so you can weave your way through the Accounting Standards Codification,” or the GAAP rule book, he says.

Balance Sheet Classification

Below, PwC explains how to classify debt as current vs. non-current.
The ASC Master Glossary defines current liabilities as:
Obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities (emphasis added).
The principal guidance for determining the balance sheet classification of liabilities is contained in ASC 210-10-45-5 through 45-12. Under that guidance, current liabilities include:

Short-term debt expected to be liquidated within one year (or operating cycle, if longer).

Current maturities of long-term obligations.

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.

Long-term obligations that are (or will be) puttable by the creditor either because the debtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation puttable or (b) the violation, if not cured within a specified grace period, will make the obligation puttable. When (1) cure of the violation is not expected within the grace period, resulting in the debt becoming puttable, (2) no waiver of the puttable debt will be granted, and (3) the company does not meet the conditions under ASC 470-10-45-13 through 45-20 for refinancing the short-term debt on a long-term basis (FG section 6.2.1).

Contingently convertible debt with a cash conversion feature (FG section 7.4) for which (1) the issuer is required to or has asserted that it will settle the par or accreted value of the bond in cash upon conversion and (2) the contingency has been met at the reporting date.
Source: PwC.

The situation is particularly difficult for smaller companies with fewer resources, says John Bishop, a partner at PwC, and it adds a layer of complexity to the audit as well. “You would think this is a pretty benign area, but it is loaded with complexities,” he says. “To comply with the exceptions requires detailed contract reviews, and the contracts can be complicated to read. They are loaded with legalese.”

The current rules on debt classification have been “cobbled together” going back as far as 50 years, says Scoles. As financial products became more complex and entities developed different ways of interpreting the rules to specific fact patterns, guidance became more specific in response. “That has led to situations where you can end up with some very similar facts and circumstances that end up with different classifications,” he says. “And it’s all based on a bunch of rules.”

As GAAP became more specific to those facts and circumstances, the markets responded with “transaction engineering” meant to achieve a desired accounting result, says Chris Wright, a managing director with Protiviti. “The form and content of deals has been subject to change so the accounting requirements can be met,” he says.

Bishop says he’s not sure all companies would cheer the elimination of detailed prescriptive guidance that enables them to achieve particular outcomes. “If we started with simply following the contractual terms, that would take a lot of complexities out, but it’s not clear that constituents would like that,” he says. “Being able to report certain short-term loans as non-current is a welcome thing, so it’s not clear to me that it would be embraced to remove those exceptions.”

Ultimately, time will tell whether simplification in debt classification or any other area of GAAP is well received in the markets, says Wright. “How long will simplification survive in the face of issuer questions about how to apply the standard?” he says. “It should be well received in theory, but it depends on how it operates in practice.”

FASB also has indicated it plans to look at whether it can simplify the accounting for debt issuance costs, although it is a separate issue from debt classification, says Gilbert. GAAP calls for fees paid to the lender vs. a third party in issuing a loan to be accounted for differently, leading to different presentation and treatment on the balance sheet. FASB says its plan is to better align the treatment of those costs.