How to Treat Debt on Your Financial Statements When You are in Violation of Loan Covenants

Nobody enjoys having to deal with debt covenant issues, but, particularly in times like these, they can be common and can have significant accounting consequences. Due to the economic hardships caused by the pandemic, many companies may find themselves in violation of one or more of their bank covenants, either at the balance sheet date or before the financial statements are available to be issued. As a result, companies may have to ask their lender for a waiver or amendment to the violation(s).

Now more than ever companies should carefully review their loan agreements and waiver documents to determine how to appropriately treat the debt at the balance sheet date. Below discusses some of the issues surrounding classification of long-term debt when a company is in violation of its covenants.

Classification of Debt with Covenants and/or Debt that is Callable

ASC 470-10-45 discusses the classification of long-term debt when there has been a covenant violation or other default at the balance sheet date and, as a result, the debt is callable by the creditor. ASC 470-10-45 also covers situations when a violation or default is anticipated within the next year. Companies should possibly consider whether debt in default at the date the financial statements are issued (or available to be issued) should be viewed similarly to debt that is in default at the balance sheet date.

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 for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower must classify the obligation as noncurrent, unless both of the following conditions exist:

1. 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.
2. It is probable the borrower will not be able to comply with the covenant at measurement dates that are within the next 12 months.

Classification of Callable Debt

Current liabilities include long-term obligations that are or will be callable by the creditor, either because the debtor's violation at the balance sheet date makes the obligation callable or because the violation, if not brought into compliance within a specified grace period, will make the obligation callable. Accordingly, callable obligations are classified as current liabilities unless either of the following conditions is met:

1. The creditor has waived or subsequently lost the right to demand repayment for more than one year (or operating cycle, if longer) from the balance sheet date. 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. If the obligation is callable because of violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations.
2. For long-term obligations containing a grace period within which the debtor may cure the violation, it is likely the violation will be cured within that period, thus preventing the obligation from becoming callable.

Drawing a distinction between significant violations of critical conditions and technical violations is not practicable. A violation that a debtor considers to be technical may be considered critical by the creditor. Furthermore, a creditor may choose to use a technical violation as a means to withdraw from its lending relationship with the debtor. If the violation is considered insignificant by the creditor, then the debtor should be able to obtain a waiver.

Example: Classification of Long-Term Debt that Includes Covenants

Let’s look at an example of how this works:

• A borrower has a long-term loan that requires compliance with certain covenants, such as maintenance of a minimum current ratio, minimum debt-to-equity ratio or minimum level of shareholders' equity.
• The borrower must meet the covenants on a quarterly or semiannual basis.
• At one of the compliance dates, the borrower violates a covenant.
• The violation gives the lender the right to call the debt; however, the lender waives that right for a period greater than one year but retains the future covenant requirements.

The issue is whether the waiver of the lender's rights, while retaining the periodic covenant tests, represents, in substance, a grace period. If viewed as a grace period, the borrower would classify the debt as current, unless it is probable the borrower can comply with the covenant within the grace period.

Specifically, the balance sheet classification of an obligation is considered in the following situations:

The standards and the implementation guidance noted above (specifically, in scenarios A, B and C) indicate that, unless facts and circumstances allude otherwise, debt should be classified as noncurrent if there is no debt covenant violation at the balance sheet date but a violation is probable within the next year. This guidance seems to indicate that these situations are similar to non-recognized subsequent event situations and, accordingly, do not warrant adjustment to the noncurrent classification of the debt at the balance sheet date.

However, some view that debt in default prior to the issuance of financial statements should be evaluated like debt in default at the balance sheet date. It’s important for companies and their accountants to understand the terms of the loan agreements, waivers, etc. to determine the appropriate accounting presentation and disclosure.

In evaluating the debt classification guidance in ASC 470-10-45, a debtor should also consider whether the default impacts other debt instruments. There may be cross-default provisions that automatically trigger an event of default if any other obligations are in default. In those cases, the other debt instruments would also be considered in default and should be evaluated under the guidance to determine the appropriate classification.

As always, individual facts and circumstances should be considered when evaluating violations occurring on or expected to occur after the balance sheet date. Within the applicable financial reporting rules and guidance there are additional nuances to consider and fully prepare for. It’s imperative to understand all of the rules to ensure the accuracy and completeness of your financial statements.

Contact Gino Scipione or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.