At its meeting yesterday, the FASB asked its staff to draft a proposed Accounting Standards Update (ASU) on simplifying the balance sheet classification of debt.

Background        

This project is part of the FASB’s simplification initiative. The objective of the project, as described in the Board’s July 29, 2015, meeting handout, is “to replace existing, fact-pattern-specific debt classification guidance with an overarching, cohesive principle to reduce cost and complexity for preparers and auditors when determining whether debt should be classified as current or noncurrent on the balance sheet, while improving the usefulness of the information reported to financial statement users.”

At its January 28, 2015, meeting, the Board tentatively agreed on a classification approach under which an entity would “classify debt as noncurrent if one or both of the following criteria are met as of the balance sheet date:

1. The liability is contractually due to be settled more than 12 months (or operating cycle, if longer) after the balance sheet date.
2. The entity has a contractual right to defer settlement of the liability for at least 12 months (or operating cycle, if longer) after the balance sheet date.”

Key tentative decisions made at the July 29, 2015, meeting are discussed below.

Scope

The proposed classification approach applies to debt arrangements that “provide a lender a contractual right to receive money and a borrower a contractual obligation to pay money on demand or on fixed or determinable dates.”

At its July 29, 2015, meeting, the Board tentatively decided to clarify that the approach applies to both (1) convertible debt (even though such instruments may be settled in shares) and (2) mandatorily redeemable financial instruments classified as liabilities under ASC 480-10¹ (even if such instruments are in the form of equity shares).

Waiver of Debt Covenant Violations

Under the Board’s proposed classification approach, the determination of whether debt is current or noncurrent is made on the basis of the facts and circumstances that exist as of the balance sheet date. This proposal differs from current U.S. GAAP, under which an entity is permitted to consider certain post-balance-sheet events, such as a post-balance-sheet-date arrangement to refinance a short-term obligation on a long-term basis.

At its July 29, 2015, meeting, the Board tentatively decided to make one exception to its proposed approach. When a debtor violates a debt covenant on or before the balance sheet date and the long-term debt becomes a short-term obligation, it should not automatically be required to classify the debt as current. If the lender grants the debtor a waiver of the covenant before the debtor’s financial statements are issued, the debtor would present the debt separately within long-term debt on the face of the balance sheet. The purpose of such presentation would be to notify financial statement users that such debt is classified as noncurrent even though the debtor violated one or more covenants as of the balance sheet date. The exception would not apply to waivers that involve a debt modification or extinguishment.

Further, the Board tentatively decided to retain existing U.S. GAAP guidance (ASC 470-10-45-1(b)) requiring that (1) the waiver of the current violation be for at least 12 months from the balance sheet date and (2) it not be “probable that the borrower will be [unable] to cure the default [comply with the covenant] at measurement dates [for the covenant] within the next 12 months.”

Subjective Acceleration Clauses²

Under the Board’s proposed classification approach, debt that is callable by the creditor or due on demand is classified as current. During the Board’s discussion on January 28, 2015, the staff suggested that debt subject to subjective acceleration clauses (SACs) would also be classified as current under the proposed classification approach.

However, at its July 29, 2015, meeting, the Board tentatively decided that SACs should affect classification only when triggered (in a manner similar to the treatment of debt covenant violations). Accordingly, a long-term obligation would be classified as noncurrent even if it is subject to an SAC. This decision differs from current U.S. GAAP, under which long-term obligations subject to SACs are sometimes classified as current (e.g., because of recurring losses or liquidity problems).

Disclosure and Transition

The Board tentatively decided to incorporate into U.S. GAAP the disclosure requirements related to debt covenant violations in SEC Regulation S-X, Rule 4-08³ (ASC 235-10-S99-1(c)). Thus, such disclosures would be required for both public and nonpublic business entities. The Board also tentatively decided to require entities to disclose the nature and existence of significant SACs and debt covenants.