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Debt covenant impact on balance sheet classification

account reconciliations, accountingQuite often, debt with lending institutions will contain certain covenants within the agreement that your company must abide by. Included with these may be certain financial covenants that must be met. For example, your company may need to maintain a level of debt service coverage or a minimum level of net worth. When these are not met, the lender could put you in default on the debt and call the loan for payment. Many times, the lender will provide a waiver for the violation, however, they are likely going to charge you for that. Furthermore, the lender may use this as an opportunity to increase the interest rate charged on the loan. Lenders set these financial covenants based upon your operating performance at the date of the loan and expectations for the future in order to restrict you in doing anything that might jeopardize their ability to collect on the loan. Accordingly, you should be well aware of the financial covenants that must be met and monitor your performance against these covenants throughout the year.

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Outside of the impact to the cost of the loan to your company, there are also balance sheet classification considerations for the debt when covenants are not met. Violations of a debt agreement that make the debt callable within one year of the balance sheet date will result in the long-term debt being classified within current liabilities unless the creditor specifically waives the right to demand payment for more than one year from the balance sheet date, or the violation is cured after the balance sheet date but before financial statements are issued (or available to be issued). In addition, if the covenant violation has a grace period to cure and your company demonstrates that it is probable that you will cure the violation during the grace period, the noncurrent presentation would be appropriate.

Lenders often will be reluctant to provide an unconditional waiver for the violation that covers the next 12 months. When this is the case and the lender retains the future covenant compliance requirements, you may still need to reflect the debt as a current liability if it is not probable that your company will be able to comply with the covenant at subsequent measurement dates that are within the next year. Also, if a covenant violation has not occurred as of year-end but occurs prior to the issuance of your annual financial statements, you will need to consider if the debt should be reflected as a current liability should there have been conditions or events that occurred at the end of the year that were leading to the violations subsequent to year-end.

Covenant violations is just one area that requires some thought and judgment related to the decision whether to present debt as current or noncurrent. The FASB currently is working on a project to simplify the balance sheet classification of debt and has issued proposed accounting standards updates related to this matter in both 2017 and 2019. The FASB is currently redeliberating the accounting standard update based upon feedback received from the revised exposure draft in 2019. It will be curious what comes out of that. Currently, it does not look like there will be any changes to the presentation of debt when there is a covenant violation at year-end, but the company obtains a waiver subsequent to year-end that meets certain requirements. However, there may be a requirement that financial statement disclosures include the fact that the covenant violation occurred. We will cover more on this subject once a final accounting standards update is issued.

Our professionals have many years of experience working with construction, dealerships, restaurants, nonprofits, governments, and technology industries. If you have an accounting question, don’t hesitate to contact a Henry+Horne professional adviser.

Jonathan Poppel, CPA