Proposal for reclassifying debt on the balance sheet slated for early 2017 publication

The FASB plans to release in early 2017 a proposal that it believes will make it easier to look at a company’s balance sheet and see how much of its debt needs to be paid quickly versus how much is owed in the future.

The proposal has been the subject of much criticism from private companies and their accountants, with many saying the plan would make businesses look more indebted than they really are. But a FASB representative said on Dec. 19, 2016, that the forthcoming proposal will be adjusted to reflect the criticism, which may make the plan more palatable.

Input from the FASB’s Private Company Council (PCC) and other private company representatives led the accounting board to make two changes to its proposal, said incoming FASB member Harold Monk on a webcast about private company and not-for-profit accounting issues.

First, the plan will call for the consideration of loan terms called subjective acceleration clauses and material adverse change clauses only when they are triggered, and not require companies to assess the probability of whether the clauses could be activated, Monk said.

Subjective acceleration clauses let creditors speed up the scheduled payments of debt. Material adverse change clauses allow a lender to change a loan’s terms or call for payment before the loan matures if a major change happens that makes the arrangement undesirable.

Lenders told the FASB that it is difficult to enforce the clauses in court, and that it is rare that they are used to call the debt. They told the FASB that the existence of such clauses should have no bearing on the classification of debt, according to the board’s background materials on the project.

Second, based on feedback from private companies, the FASB plan retains current GAAP for the effect of a violation of a debt covenant on the debt’s classification.

“That leaves us with the continued ability to treat the clearance of debt covenants after year end to allow for treating the debt as long term as opposed to current,” said Monk, who is a past member of the PCC and starts on the FASB on Jan. 1, 2017. Monk is filling the vacancy created by the departure of Daryl Buck.

The proposed changes will apply to both private and public companies, he said.

The FASB has heard many concerns about the debt classification plan, with members of the PCC and the AICPA’s Private Companies Practice Section saying it would make more debts look current and harm companies’ creditworthiness. Others said businesses that must have clean finances to receive permits to bid on government contracts would have difficulty qualifying as bidders because of the proposed balance sheet classification rules.

The FASB took on the project in August 2014 as a way to improve and simplify the distinctions for classifying short-term and long-term liabilities on balance sheets. The difference is important to companies that want to clearly distinguish between debt that must be paid in the near future and the debt for which they have more time to make payments.

Under the FASB plan, the classification of current or noncurrent would be based on the terms of the debt as of the balance sheet date. A business’s debt would be labeled as noncurrent if it is due to be settled more than a year after the reporting period, or if the business has the right to defer settlement for at least a year.

A material adverse change clause or a debt acceleration clause will be used in determining the debt classification only when the clause is triggered. Violations of debt covenants that are cleared at year-end also will not cause debt to be treated as current.

The existing guidance for debt in Topic 470, Debt, requires financial executives and auditors to consider specific rules that depend on the type of debt arrangement, such as a loan covenant, revolving credit, and some specialized types of loans. But the guidance does not cover all scenarios. The FASB wanted to amend the standard to include an overarching principle to classify debt based on a contract’s terms and the company’s compliance with the loan or bond covenants.

The FASB also addressed a part of Topic 470 that requires debt to be classified as noncurrent if it is “probable that the borrower will not be able to cure the default at measurement dates within the next 12 months.”

In July 2015, the FASB agreed to retain this probability assessment for waivers of debt covenant violations received after the balance sheet date but before the financial statements are issued.

The FASB also decided to drop a potential disclosure requirement to identify subjective acceleration clauses because its research staff found that the clauses are rarely enforced by lenders.

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