Over the past few years, the Financial Accounting Standards Board (FASB) has embarked on a project to simplify and strengthen its reporting framework in accordance with the United States Generally Accepted Accounting Principles (GAAP). One of the simplification projects currently on the FASB’s agenda is debt classification. In 2017, FASB unanimously agreed to submit a proposal on this topic.
The board heard comments from stakeholders that the guidelines for classifying debt balance sheets were unnecessarily complex. To reduce complexity, the Board decided to consider replacing the current narrow range of guidance with principle-based guidance. In GAAP, short-term liabilities refinanced after the balance sheet date and before the financial statements are issued are recorded as non-current liabilities. The FASB has agreed to propose a change in the classification of the debt to reflect the situation at the balance sheet date.
This means that refinancing incurred after the reporting date is classified as current liabilities. For a liability to be classified as non-current, it must have a contractual right to settle or postpone settlement at least one year after the date of the balance sheet. Classification of debts in the balance sheet is important as it helps stakeholders who read financial statements of a company such as investors to understand the real worth of a company.
Assets and liabilities created in the balance sheet to help companies to monitor their financial position. Both are divided into current and non-current to show when a company need to convert to cash (asset) or redemption (liability) (Kulikova & Semenichina, 2016). Current refers to a period of less than 12 months, and non-current refers to a period of 12 months or more.
Current assets include cash and other accounts receivable (amount owed from customers or debtors) and items that are likely to be converted into cash within 12 months, such as stocks and other assets that will be sold within 12 months (Kulikova & Semenichina, 2016). Assets listed after liquid assets are fixed assets, which will continue to exist for more than 12 months in their current form (not cash). Fixed assets can include office equipment, furniture, tools, and corporate vehicles.
Debts are listed on the balance sheet depending on when they need to be paid off. Current liabilities that must be repaid within 12 months are listed first. Then the non-current liabilities which are due 12 months later are listed second, followed by shareholder funds (capital) (Khamidullina & Arzhantseva, 2015). Current debt typically includes money owed to the supplier, credit card debt, and bank overdraft. Non-current liabilities may include loans from external stakeholders.
It is important to understand a balance sheet because the balance sheet provides a picture of the financial strength of the business at a certain point in time (usually at the end of the month or fiscal year). It clearly reports if a company owe more money than what it currently have, the present value of its assets and the overall value of the business (Gerstner, 2016). More importantly through the use of financial ratios, a balance sheet can provide a clear report on whether a company is in good financial position or not.
Having this knowledge can help a company to find solution to financial problems before they affect the performance of the business (GASB, n.d). The balance sheet changes with each transaction, so it is an important element of a financial statement that should be reviewed regularly and entries must be classified accordingly.
Several organizations have faced a dilemma on whether to classify a debt as current or non-current. Although the GAAP set standards on how financial tries must be recorded in the balance sheet, debt classification has been a challenge for many auditors as there are several factors that influence it. This includes factors such as management expectations and contractual agreements between the borrower and receiver which sometimes change from time to time as influenced by macro-economic conditions (FASB. Org, 2020).
The FASB also provided guidelines on the various ways in which debt can be classified. This includes the question of whether to classify the debt as current or non-current liability. Some guidelines have focused on management’s expectations of when the debt will be settled, while others have focused on the terms of the contract.
To avoid this complexity, the board decided to adjust the guidelines according to a single principle surrounding the terms of the contract. This is because the principles based on the terms of the contract are more objective than the evidence provided by management’s expectations (FASB. Org, 2020). Amendments to the classification of liabilities in the balance sheet were now considered a simple contract if the author applied and carried out an audit compared to GAAP (FASB. Org, 2020). In addition, users of financial statements have expressed concern that principles based on management expectations are subjective and can lead to financial complications within the company over time as expectations might not be consistent.
For example, if two companies use the same basic terms within their debt agreement, the management of each company may have different expectations about when the debt will be settled (FASB. Org, 2020). If the classification of the debt is based on the expectations of management, the debt can be classified as current liabilities of one company and non-current liabilities of another (FASB. Org, 2020). Because of this inconsistency the FASB decided to implement a strategy that helps with consistency of the classification approach that aligns with the way current and non-current liabilities are defined.
Passing their judgment, the board stipulated that an entity cannot reasonably expect a debt to be a non-current liability if it does not have a contractual right to support that expectation. For example, if a company has a debt within 6 months, it is unfair for management to argue that the debt is non-current debt as expected (FASB. Org, 2020). If management wants to refinance the debt in a subsequent period, the company must agree to the lender’s refinancing.
In this regard, the FASB has issued a proposal to reduce the cost and complexity of determining whether the debt should be classified as current or non-current on its classified balance sheet. The FASB decided to clarify and define the classification of debt based on the feedback and proposals given by companies (FASB. Org, 2020). Some of the feedback received from the company stated that the existing guidelines for classifying the balance sheet of debt are unnecessarily complex.
Stakeholder feedback also suggested that the board should replace the current fact-specific guidelines with a unified principle for determining debt classification (FASB. Org, 2020). In addition, stakeholders suggested that it is necessary to clarify the impact of violations of the agreement on balance sheet entry, clarification of the exemption of the agreement, refinance after the balance sheet, and clarify the subjective acceleration clause (SAC) for the classification of debt.
The first proposal for the Directive on Classification of Debt was published in 2017. This applied to all companies with debt commitments, including debt securities, loan agreements, and revolving credit commitments (FASB. Org, 2020). In accordance with the proposal, a debt arrangement is defined as an arrangement that provides the borrower with the right to pay money owed (FASB. Org, 2020).
These arrangements include (1) equity financial instruments in a legal form denoted as liabilities because they meet the definition of mandatory repayment financial instruments, (2) convertible liabilities instruments, and (3) lease liabilities. However, this arrangement did not affect companies that do not present a classified balance sheet. This included companies that did not have a contractual right to postpone payment or liabilities for at least one year (or operating cycle if longer) after the balance sheet date.
The proposed debt classification principle means that debts not settled by contract within 12 months of the balance sheet date are generally classified as non-current debts, even if the debtor expects to settle the debt within that period (FASB. Org, 2020). Unlike traditional GAAP, this principle applies even if the borrower is or is expected to violate a debt arrangement (such as recurring losses or liquidity (FASB. Org, 2020). In this case, the debt is classified if the borrower violates the terms of the long-term debt arrangement as of the balance sheet date and the debt arrangement provides a specified grace period for the debtor to comply with the rules before the debt arrangement can require payment.
In addition, upon notice from the lender that the borrower is not in compliance, debt will be classified as non-current liabilities (FASB.Org, 2020). Conversely, the proposal suggested an exemption exception if the current the liabilities that must be settled by the contract within 12 months from the date of the balance sheet are not settled. According to the proposed guidelines, short-term debts are classified as current liabilities even if the entity expects refinancing under long-term financial contracts, but in existing GAAP, it is classified as non-current due to the presence of long-term financial contracts. The new proposal suggested classification of short debts when certain criteria were met.
The entity did not classify the debt as a current debt due to a breach of a debt agreement that gives the lender the right to demand repayment of the debt as long as the borrower has previously not paid (FASB. Org, 2020). For debts falling under this exception, the following conditions must be met: Waiver is for at least one year (or operating cycle if longer) from the date of the balance sheet (FASB.Org, 2020). The waiver does not lead to an amendment that is considered a debt extinction under ASC 470-50 or a debt restructuring issue under ASC 470-60. There is no possibility of breaching other contracts in the debt contract within 12 months (or operating cycles if longer) from the balance sheet date (FASB. Org, 2020).
Liabilities may be classified as non-current as of the balance sheet date if there are no contract violations. In addition, the amount of the liability classified as non-current due to the exemption exception must be indicated separately in the classification balance sheet (FASB. Org, 2020). Although there are already commitment exemption exceptions under US GAAP as of now, the offer to require companies to separately present amounts of debt classified as non-current due to this exception is new. The example below shows the balance sheet presentation of non-current liabilities resulting from a change in the commitment exemption exception under the proposed ASU.
As of December 31, 2018, Lion Logix has outstanding long-term debt of $100 million. Out of $100 million, $35 million is the default as of the balance sheet date. However, Lion Logix was exempted from default prior to filing its financial statements. The proposed ASU explains that the commitment exemption exception require Lion Logix to present $35 million within non-current liability when certain conditions are met, but must separately present the amount of the liability classified as non-current as a result of the exemption exception. (I.e. $35 million).
The proposal has changed the classification of short-term liabilities that companies expect to refinance in the long run (e.g. letter of credit, line of credit or other long-term financing agreements). Previously, US GAAP classified short-term debt as non-current if an entity has the intention and ability to refinance the debt over the long term, as evidenced by the issuance of long-term debt or equity securities and an expressly permitted financial contract. Enterprises to refinance after the balance sheet date or in the long run (FASB. Org, 2020). Conversely, the proposed ASU banned businesses from considering refinancing transactions that occurred after the balance sheet date (FASB.Org, 2020).
Therefore, short-term debts are classified as current debts, if they are willing to refinance in the long run and, if possible. The FASB considered an alternative approach that should consider some or all of the unused long-term financial contracts when classifying debt as current or non-current (Deloitte, 2018). If under this approach an entity had a qualifying long-term financing arrangement, the short-term debt would have been classified as non-current based on the contractual link between the debt and the long-term financing contract, for example. Balance sheet date
Businesses should consider the timing of their refinancing plans and their potential impact on short-term debt classification. Based on the background information and conclusions of the proposed ASU, the board stipulated that the company should classify the convertible liabilities based on when the liabilities are contractually settled in cash or other assets as opposed to when the liabilities may arise (Pwc, 2020). If the contractually stipulates in the debt contract that the settlement must be made entirely of shares, the entity decides on the classification based on the contractual debt maturity date, regardless of the form of the settlement.
Another FABS proposal was for companies to disclose information about all underlying events. This included notice from the lender that the loan agreement was breached or that the description of the default was implemented. Secondly, companies must include the amount of obligations (including the period of exemption, if applicable) for the terms of default and exemption (). The following additional disclosure was required. Financial statements must be issued if the entity violated the provisions of long-term debt commitments and the breach was not previously corrected during the period during which the debt commitment provided a grace period for expiration after the balance sheet date (Tysiac, 2019). If financial statements have been issued, but the violations have not been corrected, at the end of the grace period, the lender has the right to demand payment for long-term debt commitments.
The balance sheet of most companies separates current assets and current liabilities (commonly referred to as classified balance sheets) so that working capital can be determined immediately. Amendments to this proposed update relate to the separate classification of current and non-current liabilities within the classified balance sheet (FASB.Org, 2020). Companies that do not present a classified balance sheet are not affected by the proposed amendment. The amendments to this proposed update apply to all companies with debt commitments (FASB.Org, 2020). Debt arrangements give the lender a contractual right to receive consideration, and the borrower has a contractual obligation to pay the consideration upon request or on a fixed or fixed date. The proposed amendments also apply to convertible debt instruments and obligation-paying financial instruments that are classified as liabilities.