How does a debt covenant violation affect the presentation of debt on a balance sheet? If a waiver from the lender is obtained, should the violation be disclosed? In this article, I will tell you how to report debt covenant violations.
Lenders commonly include debt covenants in loan agreements. Those covenants might require certain profitability, liquidity, or cash flow ratios. A violation of such requirements can make long-term debt callable. And, by definition, the debt becomes current since it is now due within one year of the balance sheet date.
If a debt covenant violation occurs, the debt should be classified as current unless the lender provides a waiver for more than one year from the balance sheet date. (See an exception below when there are subsequent measurement dates within one year of the balance sheet date.)
How should debt be classified if a cure occurs prior to the issuance of the financial statements? Debt is shown as noncurrent if the company is able to cure a violation subsequent to the balance sheet date but before the issuance date (or date available for issuance) of the financial statements.
Additionally, some loans provide for a grace period. If the violation is cured during the grace period, the debt will be reported as long-term. Also if the cure has not already occurred but the company demonstrates it is probable that the cure will occur within the grace period, then the debt will be reported as long-term.
Reporting Debt Covenant Violations
When a violation occurs, the main consideration in classifying long-term debt is whether the amount is due or callable within one year of the balance sheet date. If the loan is due or callable within the year after the period-end, the amount generally should be reported as current. If a debt covenant violation is timely cured within a grace period, then the debt is no longer callable and will, therefore, remain long-term. Noncurrent classification is also appropriate if the creditor provides a waiver that extends more than one year beyond the balance sheet date.
Waivers do not, however, guarantee long-term debt classification, particularly if there are other measurement dates within the year after the period-end.
Subsequent Measurement Dates
470-10-45 of the FASB Codification provides the following guidance:
Some long-term loans require compliance with quarterly or semiannual 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. 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.
b. 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.
If both of these conditions exist, then the debt is shown as current.
Consider a scenario where a company has a covenant violation on December 31, 2019, and it obtains a waiver from the lender that lasts through January 1, 2021. If a September 30, 2020 measurement date is required by the loan agreement and it is probable that the company will not be in compliance, then the loan is classified as current on December 31, 2019, even though the waiver was obtained. Why? The new violation would make the loan callable within one year of the balance sheet date. (The prior waiver was in relation to the December 31, 2019 violation, not a subsequent violation.)
Is Disclosure Required if a Waiver is Obtained?
If a company obtains a waiver for more than one year from the balance sheet date, must the financials disclose this fact (that a waiver was obtained)?
The AICPA answers this question–in Q&A section 3200 (paragraph 17)–with the following:
The authoritative literature applicable to nonpublic entities does not address disclosure of debt covenant violations existing at the balance-sheet date that have been waived by the creditor for a stated period of time. Nevertheless, disclosure of the existing violation(s) and the waiver period should be considered* for reasons of adequate disclosure. If the covenant violation resulted from nonpayment of principal or interest on the debt, inability to maintain required financial ratios or other such financial covenants, that information may be vital to users of the financial statements even though the debt is not callable.
*Emphasis added by CPAHallTalk
Translation: It is wise to disclose the debt covenant violation and the existence of the waiver.
FASB’s Current Work on a New Debt Standard
The FASB has an ongoing project regarding the classification of debt. The FASB issued a revised Exposure Draft on September 12, 2019, Debt (Topic 470): Simplifying the Classification of Debt in a Classified Balance Sheet (Current versus Noncurrent). Comments were due October 28, 2019. It has taken FASB over two years to deliberate this topic. So you call tell the classification decision is not an easy one.
Additional Information About Auditing Debt
See my post regarding the audit of debt.