DEBT COVENANTS AND POTENTIAL IMPACT ON DEBT CLASSIFICATION

In light of COVID-19 and its negative financial impact on businesses within certain industries, it is important to understand the potential impact that debt covenants can have on financial reporting. Most debt instruments contain at least one if not several covenants. A covenant represents a condition placed on the borrower by the lender whereby the borrower may be required to meet certain conditions or be subject to certain restrictions. Examples of covenants include financial covenants such as a requirement for the borrower to maintain a certain level of earnings, cash flow, EBITDA, working capital, current ratio, debt to equity ratio, interest coverage ratio, etc. A common informational covenant is the requirement for the borrower to provide audited financial statements (usually in accordance with US GAAP) to the lender within a certain time period after year end (90 or 120 day requirements are common). Lenders require covenants in order to ensure the credit quality or riskiness of the borrower does not deteriorate prior to the maturity of the loan. Covenant violations often result in the lender obtaining the right to call or demand early repayment of the loan, impose additional fees, and/or modify the terms of the debt instrument.

In addition to the economic consequences of covenant violations, there is also the potential for an impact on the classification (current versus noncurrent) of the debt instrument under US GAAP. ASC 470 Debt provides the authoritative literature on the classification of debt that includes covenants. This guidance can be complicated and difficult to understand. The guidance starts by illustrating the following scenario involving a covenant violation and waiver: A covenant violation occurs that would otherwise give the lender the right to call the debt and the lender waives 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 the measurement dates that are within the next 12 months.

The following examples help illustrate the application of this guidance. For all of the examples below, assume a borrower has a calendar year end (December 31) and is subject to debt covenants at year end and on a quarterly basis.

The borrower violates the covenant at year end and obtains a waiver from the lender for a period greater than a year related to the year end violation. The lender retains its right to act on the future quarterly covenants and it is probable that the borrower will be in compliance with the future quarterly covenants for the next 12 months. This debt would be classified as noncurrent.

The borrower violates the covenant at year end and obtains a waiver from the lender for a period greater than a year related to the year end violation. The lender retains its right to act on the future quarterly covenants and it is not probable that the borrower will be in compliance with the future quarterly covenants for the next 12 months. This debt would be classified as current.

The borrower is in compliance with the covenant at year end, however it is not probable that the borrower will be in compliance with the future quarterly covenant for the next 12 months. This debt would be classified as noncurrent.

Prior to year end, the borrower negotiates a modification of the loan agreement that eliminates the covenant requirement at year end or modifies the covenant so that the borrower will comply. Absent the modification, the borrower would have been in violation of the covenant at year end. The lender retains its right to act on the future quarterly covenants and it is not probable that the borrower will be in compliance with the future quarterly covenants for the next 12 months. This debt would be classified as current. US GAAP requires a relatively limited number of disclosures related to debt covenant violations. The guidance requires disclosure if it is not probable that a borrower will comply with its future covenants after year end. While the guidance does not require specific disclosure related to covenant violations and waivers obtained, it is common practice to disclose these events as they most likely represent information that is useful to the users of the financial statements and is necessary to understand the borrower’s liquidity and risks. The classification of debt as current can also have a significant impact on other accounting areas, most notably the assessment of the borrower’s ability to continue as a going concern.

The FASB began working on a debt classification simplification project in 2014, with its first proposal issued in[redacted]A subsequent proposal was issued in[redacted]Proposed ASU[redacted]The proposal would simplify much of the overall debt classification guidance, including the guidance related to covenants. As of the date of this article, no final guidance has been issued by the FASB.



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