Classification of debt that includes covenants

Some long-term loans require compliance with certain covenants that must be met on a quarterly or semiannual basis. If a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions exist:

• A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
• It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.

Subjective acceleration clauses

In some situations, the circumstances (for example, recurring losses or liquidity problems) would indicate that long-term debt subject to an acceleration clause should be classified as a current liability. Other situations would indicate that only disclosure of the existence of the acceleration clause is needed. Neither reclassification nor disclosure would be required if the likelihood of the acceleration of the due date were remote, such as if the lender historically has not accelerated due dates of loans containing similar clauses and the financial condition of the borrower is strong and its prospects are bright.

Classification of revolving credit agreements subject to lock-box arrangements and subjective acceleration clauses

Borrowings outstanding under certain revolving credit agreements are considered long-term debt because the borrowings are due at the end of a specified period (for example, three years) rather than when short-term notes roll over (for example, every 90 days). Borrowings may be collateralized, but the only note is the overall note signed at the agreement’s inception. Some agreements contain contractual provisions that require, in the ordinary course of business and without another event occurring, the cash receipts of a debtor be used to repay the existing obligation; this is commonly referred to as a lock-box agreement.

Borrowings outstanding under a revolving credit agreement that includes both a subjective acceleration clause and a requirement to maintain a lock-box arrangement shall be considered short-term obligations. Accordingly, because of the subjective acceleration clause, the debt shall be classified as a current liability unless the entity intends to refinance the obligation on a long-term basis and conditions are met to refinance the obligation after the balance sheet date on a long-term basis.

Borrowings outstanding under a revolving credit agreement that includes both a subjective acceleration clause and a requirement to maintain a springing lock-box arrangement shall be considered long-term obligations because the remittances do not automatically reduce the debt outstanding without another event occurring.

On-demand loan arrangements

Loan agreements may specify the debtor’s repayment terms but also enable the creditor, at his discretion, to demand payment at any time. Those loan arrangements may have wording such as either of the following:

• “The term note shall mature in monthly installments as set forth therein or on demand, whichever is earlier.”
• “Principal and interest shall be due on demand, or if no demand is made, in quarterly installments beginning on . . .”

An on-demand provision is not a subjective acceleration clause. A current liability classification would include obligations that, by their terms, are due on demand or will be due on demand within one year, or operating cycle, if longer from the balance sheet date, even though liquidation may not be expected within that period.

Callable debt

A debtor’s current liabilities should include long-term obligations that are, or will be, callable by the creditor when the debtor has violated a provision of the debt agreement at the balance sheet date that makes the obligation callable, or because the violation, if not cured within a specified grace period, will make the obligation callable. Accordingly, such callable obligations should be classified as current liabilities unless either of the following conditions is met:

• The creditor has waived or subsequently lost (for example, the debtor has cured the violation after the balance sheet date and the obligation is not callable at the time the financial statements are issued or are available to be issued) the right to demand repayment for more than one year, or operating cycle, if longer, from the balance sheet date. If the obligation is callable because of the violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations.
• For long-term obligations containing a grace period within which the debtor may cure the violation, it is probable that the violation will be cured within that period, therefore preventing the obligation from becoming callable.

Making a distinction between significant violations of critical conditions and technical violations is not practicable and if a violation is considered insignificant by the creditor, then the debtor should be able to obtain a waiver.

Refinancing short-term debt

Some short-term obligations are expected to be refinanced on a long-term basis and, therefore, are not expected to require the use of working capital during the ensuing fiscal year. Examples include commercial paper, construction loans, and the currently maturing portion of long-term debt.

Refinancing a short-term obligation on a long-term basis means either replacing it with a long-term obligation or with equity securities or renewing, extending, or replacing it with short-term obligations for an uninterrupted period extending beyond one year (or the operating cycle, if applicable) from the date of an entity’s balance sheet.

Short-term obligations arising from transactions in the normal course of business that are due in customary terms shall be classified as current liabilities. A short-term obligation should be excluded from current liabilities if the entity intends to refinance the obligation on a long-term basis and the intent to refinance the short-term obligation on a long-term basis is supported by an ability to consummate the refinancing demonstrated in either of the following ways:

• Post-balance-sheet-date issuance of a long-term obligation or equity securities
• Before the balance sheet is issued or is available to be issued, the entity has entered into a financing agreement that clearly permits the entity to refinance the short-term obligation on a long-term basis on terms that are readily determinable, and all of the following conditions are met:
  • The agreement does not expire within one year — or operating cycle — from the date of the entity’s balance sheet and during that period the agreement is not cancelable by the lender or the prospective lender or investor (and obligations incurred under the agreement are not callable during that period) except for violation of a provision with which compliance is objectively determinable or measurable.
  • No violation of any provision in the financing agreement exists at the balance sheet date and no available information indicates that a violation has occurred thereafter but before the balance sheet is issued or is available to be issued or, if one exists at the balance sheet date or has occurred thereafter, a waiver has been obtained.
  • The lender or the prospective lender or investor with which the entity has entered into the financing agreement is expected to be financially capable of honoring the agreement.

Be aware of the following when refinancing short-term obligations:

• If a short-term obligation is repaid after the balance sheet date and subsequently a long-term obligation or equity securities are issued, whose proceeds are used to replenish current assets before the balance sheet is issued or is available to be issued, the short-term obligation should not be excluded from current liabilities at the balance sheet date.
• If an entity’s ability to consummate an intended refinancing of a short-term obligation on a long-term basis is demonstrated by post-balance-sheet-date issuance of a long-term obligation or equity securities, the amount of the short-term obligation to be excluded from current liabilities should not exceed the proceeds of the new long-term obligation or the equity securities issued.
• If the ability to refinance is demonstrated by the existence of a financing agreement, the amount of the short-term obligation to be excluded from current liabilities shall be reduced to the amount available for refinancing under the agreement if the amount available is less than the amount of the short-term obligation. That amount should be reduced further if information, such as restrictions in other agreements or restrictions as to transferability of funds, indicates that funds obtainable under the agreement will not be available to liquidate the short-term obligation.
• If amounts that could be obtained under the financing agreement fluctuate, then the amount to be excluded from current liabilities should be limited to a reasonable estimate of the minimum amount expected to be available at any date from the scheduled maturity of the short-term obligation to the end of the fiscal year. If no reasonable estimate can be made, the entire outstanding short-term obligation should be included in current liabilities.

Detachable warrants

Debt with detachable warrants (detachable call options) to purchase stock is usually issued with the expectation that the debt will be repaid when it matures. The provisions of the debt agreement are usually more restrictive on the issuer and more protective of the investor than those for convertible debt. The terms of the warrants are influenced by the desire for a successful debt financing. Detachable warrants often trade separately from the debt instrument. Therefore, the two elements of the security exist independently and may be treated as separate securities.

From the point of view of the issuer, the sale of a debt security with warrants results in a lower cash interest cost than would otherwise be possible or permits financing not otherwise practicable. The issuer usually cannot force the holders of the warrants to exercise them and purchase the stock. The issuer may, however, be required to issue shares of stock at some future date at a price lower than the market price existing at that time, as is true in the case of the conversion option of convertible debt. Under different conditions the warrants may expire without exercise; therefore, the outcome of the warrant feature cannot be determined at the time of issuance. In either case, the debt must generally be paid at maturity or earlier redemption date whether or not the warrants are exercised.

Proceeds from the sale of a debt instrument with stock purchase warrants (detachable call options) shall be allocated between the warrant and the debt instrument based on their relative fair value. The portion of the proceeds allocated to the warrant is accounted for as paid-in capital and the remaining portion of the proceeds to the debt instrument.

Convertible debt

A convertible debt security is a complex hybrid instrument bearing an option. These alternative choices cannot exist independently of one another because the holder ordinarily does not sell one right and retain the other. Furthermore, the two choices are mutually exclusive, because they cannot both be consummated. Therefore, the security will either be converted into common stock or be redeemed for cash. The holder cannot exercise the option to convert unless they forgo the right to redemption and vice versa.

Convertible debt features may vary, as does the accounting for such complex instruments. Following are a few examples:

• Some entities may issue convertible debt securities and convertible preferred stock with a beneficial conversion feature. Those instruments may be convertible into common stock at the lower of a conversion rate fixed at the commitment date or a fixed discount to the market price of the common stock at the date of conversion.
• Some convertible instruments may have a contingently adjustable conversion ratio.
• Some convertible debt instruments include provisions that can induce conversion, thereby allowing the debtor to alter terms of the debt to the benefit of debt holders or may be converted upon the exercise of a call option at the option of the holder.
• A convertible instrument may be issued to a nonemployee in exchange for goods or services or a combination of goods or services and cash and may contain a nondetachable conversion option that permits the holder to convert the instrument into the issuer’s stock.
• An entity may enter into various share lending arrangements.

When a convertible debt instrument is converted to equity securities, sometimes the terms of conversion provide that any accrued but unpaid interest at the date of conversion is forfeited by the former debt holder. This occurs either because the conversion date falls between interest payment dates or because there are no interest payment dates (a zero-coupon convertible instrument).