Chapter 13 — Balance Sheet Classification

13.5 Credit-Related Covenant Violations That Cause Debt to Become Repayable

13.5.1 General

ASC 470-10

45-11 Current liabilities shall include long-term obligations that are or will be callable by the creditor either because the debtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not cured within a specified grace period, will make the obligation callable. . . .

If an entity violates an objectively determinable covenant on a long-term debt arrangement, the contractual terms might accelerate the debt’s due date or give the creditor the right to accelerate the debt’s due date. Long-term debt that has become payable on demand or within one year (or the operating cycle, if longer) after the balance sheet date because of a covenant violation that has occurred as of the balance sheet date or, in the case of credit-related covenants, after the balance sheet date but before the financial statements are issued (or available to be issued) (see Section 13.5.2.2) generally must be classified as current. This is the case even if the creditor has not demanded repayment and there is no indication that it will do so. However, a credit-related covenant violation in a long-term obligation does not trigger current classification if one of the following exceptions in ASC 470-10 applies:

Covenant waiver — The debtor obtains a covenant waiver that meets the requirements in ASC 470-10-45-1 and ASC 470-10-45-11(a) before the financial statements are issued or are available to be issued (see Sections 13.5.3.2 and 13.5.3.3).
Grace period — The debt contains a grace period and it is probable that the violation will be cured within such period (see ASC 470-10-45-11(b) and Section 13.5.3.4).
Refinancing arrangement — The debtor has the intent and ability to refinance the obligation on a long-term basis (see Section 13.7).

To apply the exceptions in ASC 470-10-45-11 that address covenant waivers and grace periods, an entity must ensure that the violated provision is related to credit (see Section 13.3.4.5). The exception for refinancing arrangements applies irrespective of whether the event is associated with credit. For a discussion of the analysis of covenant violations that are not credit-related, see Section 13.4.3.

13.5.2 Scope

13.5.2.1 Background

This section discusses credit-related covenant violations that occur after the balance sheet date but before the financial statements are issued or available to be issued (see the next section), debt modifications that are made to avoid a covenant violation (see Section 13.5.2.3), and credit-related covenant violations that are cured before the financial statements are issued or available to be issued (see Section 13.5.2.4).

13.5.2.2 Covenant Violation After the Balance Sheet Date

The classification implications of credit-related debt covenant violations that occur after the balance sheet date but before the financial statements are issued or available to be issued are generally consistent with the requirements triggered by a violation as of the balance sheet date (see Section 13.5.1). A debt covenant violation that occurs after the balance sheet date but before the financial statements are issued or available to be issued would generally be an example of other “facts and circumstances,” as discussed in ASC 470-10-45-1 (see Section 13.5.3.3), under which current classification of the debt would be required unless one of the exceptions described in Section 13.5.3 applies. We have confirmed this position through informal discussions with the SEC staff.

Such scenarios primarily involve credit-related debt covenants, including those associated with quantitative financial metrics or ratios and those regarding going-concern matters. In some circumstances, the violation may be unrelated to credit or may be the result of a discrete event after year-end (e.g., a debt covenant that is triggered upon a sale of specified assets that occurred after year-end). We encourage entities to consult their advisers in these situations to determine the appropriate classification guidelines to apply.

Sometimes, a debtor might expect that it will violate a credit-related debt covenant only after the financial statements have been issued or are available to be issued. Unless the debtor is virtually certain that it will violate the covenant after such time, it should not classify the debt as a current liability on the basis of such anticipated covenant violation.

Example 13-3

Debt That Becomes Due on Demand as a Result of a Going-Concern Audit Opinion

Company ABC has a long-term loan that requires it to (1) comply with quantitative ratios, including liquidity ratios (e.g., current ratio, quick ratio) and financial leverage ratios (e.g., debt ratio, debt-to-equity ratio), and (2) obtain an audit opinion on its annual financial statements that is not subject to any qualifications or exceptions with respect to the scope of the audit or that contains a going-concern emphasis. If ABC does not comply with each of these covenant requirements, the lender has the ability to require repayment of the debt immediately. As of December 31, 20X1, ABC is in compliance with all of the quantitative ratios; however, the audit opinion issued for December 31, 20X1, will contain a going-concern emphasis. Company ABC does not obtain a waiver from the lender.

Because of the going-concern emphasis in the audit opinion, ABC should classify the loan as a current obligation in its December 31, 20X1, balance sheet. Although the audit opinion is issued after the balance sheet date, under ASC 470-10-45-1, such a known violation as of the date financial statements are issued or available to be issued would be considered an example of other “facts and circumstances” under which current classification of the debt would be required as of December 31, 20X1.

Example 13-4

Debt That Becomes Due on Demand Because of Failure to Satisfy Quantitative Covenants

Company ABC has a long-term loan that requires it to comply with quantitative ratios, including liquidity ratios (e.g., current ratio, quick ratio) and financial leverage ratios (e.g., debt ratio, debt-to-equity ratio). If ABC does not comply with each of these covenant requirements, the lender has the ability to require repayment of the debt immediately. Assume that ABC violated one of the quantitative ratio covenants as of a measurement date after the balance sheet date but before issuance of the financial statements. Assume also that ABC has obtained a waiver related to the specific violation before issuance of the financial statements for the year ended December 31, 20X1, and that ABC believes that it is probable that it will fail to meet the same covenant requirement again as of measurement dates occurring within the 12 months after December 31, 20X1.

In this situation, the covenant violation after the balance sheet date but before financial statement issuance should be viewed in the same way as a violation as of the balance sheet date (i.e., the violation constitutes evidence of “other facts and circumstances” as discussed in ASC 470-10-45-1). Since it is probable that ABC will not be able to comply with the same covenant as of compliance dates within 12 months of the balance sheet date, the debt should be classified as current as of December 31, 20X1.

13.5.2.3 Covenant Violation Would Have Occurred in the Absence of Debt Modification

ASC 470-10-55-4(d) and ASC 470-10-55-6 (see Section 13.5.3.3) indicate that a modification of the contractual terms of a debt obligation before the balance sheet date should be analyzed as a covenant violation as of the balance sheet date if all of the following conditions are met:

The modification removes or adjusts the covenant so that the debtor will comply as of the balance sheet date.
In the absence of the modification, the debtor would have violated the covenant as of the balance sheet date.
The same or a more restrictive covenant must be met as of the compliance dates after the balance sheet date.

A debt modification that meets the above conditions is treated as a covenant waiver under ASC 470-10, even though no covenant violation exists as of the balance sheet date, because a covenant violation would have occurred notwithstanding the modification (i.e., in substance, the modification represents a waiver).

13.5.2.4 Covenant Violation Cured Before the Financial Statements Are Issued or Available to Be Issued

If a debtor cures a credit-related covenant violation before the financial statements are issued or available to be issued or before the creditor otherwise loses its right to demand repayment for more than one year (or the operating cycle, if longer) after the balance sheet date, the debt is classified as noncurrent (see ASC 470-10-45-11(a) and Section 13.5.3.2). For example, if a long-term debt obligation contains a put option that may be exercised by the creditor because of a covenant violation, but such option is only exercisable for 30 days after the balance sheet date, noncurrent classification is appropriate since the put option expired before the issuance of the financial statements.

13.5.3 Exceptions to the Current-Classification Requirements

13.5.3.1 Background

Violation of a covenant in a long-term obligation that makes the debt repayable on demand does not cause the debt to be classified as current if an exception in ASC 470-10 related to one or more of the following applies:

Covenant waivers and cures (see Section 13.5.3.2).
Grace periods (see Section 13.5.3.4).
Refinancing arrangements (see Section 13.7).

13.5.3.2 Covenant Waivers and Cures

ASC 470-10

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 [as discussed in Section 855-10-25]) 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 violations of certain provisions of the debt agreement, the creditor needs to waive its right with regard only to those violations. . . .

Long-term obligations that become payable on demand or within one year (or the operating cycle, if longer) after the balance sheet date because of a covenant violation are classified as current liabilities unless the debtor obtains a covenant waiver that meets the requirements in ASC 470-10-45-1 and ASC 470-10-45-11(a) before the financial statements are issued or are available to be issued. Such debt would qualify as noncurrent if the creditor either waives its right to demand repayment under the specific covenant that was violated or otherwise loses its right to demand repayment (e.g., because the debtor cures the violation) for a period of more than one year after the balance sheet date. However, noncurrent classification would not be permitted if the creditor retains its right to demand repayment with respect to future covenant violations and it is probable that the debtor will violate the same or a more restrictive covenant as of measurement dates that are within 12 months of the balance sheet date (see Section 13.5.3.3). To apply the exception in ASC 470-10-45-11(a) for covenant waivers, an entity must ensure that the violated provision is related to credit (see Section 13.3.4.5). For a discussion of the analysis of covenant violations that are not credit-related, see Section 13.4.3.

Debt cannot be classified as noncurrent unless a waiver is binding and eliminates the creditor’s right to demand repayment of the debt within one year (or the operating cycle, if longer) after the balance sheet date as a result of the covenant violation. If the creditor has a right to revoke the waiver at its sole discretion, the waiver would not meet this condition. Further, a creditor’s statement that it does not intend or expect to demand repayment in the event of a covenant violation does not represent a waiver. A debtor is not permitted to consider the likelihood that a creditor will grant a waiver in the future even if the creditor has historically issued a waiver for the same type of violation or other covenant violations.

Lenders often request something in exchange for a covenant waiver. For example, the parties might agree to an up-front fee, an increase to the interest rate, a principal modification, the addition of a cross-default provision, or additional collateral. Since such changes represent modifications to the contractual terms of the original debt instrument, the debtor should consider whether the modifications are TDRs under ASC 470-60 (see Chapter 11) and, if not, whether to account for them as an extinguishment or modification of the original debt under ASC 470-50 (see Chapter 10). Unless it performs the necessary calculations, an entity cannot assume that the payment of a fee to obtain a debt covenant waiver does not pass the 10 percent cash flow test under ASC 470-50 (see Section 10.3.3).

13.5.3.3 Recurring Covenant Tests

ASC 470-10

45-1 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.

See Example 1 (paragraph 470-10-55-2) for an illustration of this classification guidance.

The contractual terms of long-term debt obligations often contain covenants that must be met on certain dates and that render the debt repayable on demand if they are not met on those dates. If such a covenant has been violated as of the balance sheet date or before the date on which the financial statements are issued or available to be issued, the debt must be classified as current unless one of the exceptions in ASC 470-10-45-11 or ASC 470-10-45-14 applies (see Section 13.5.3.1).

ASC 470-10-45-1 addresses the application of ASC 470-10-45-11 to covenant waivers (see Section 13.5.3.2) in situations in which the creditor has waived the specific covenant that was violated as of the balance sheet date but retains its right to demand debt repayment if the debtor violates the same or a more restrictive covenant on subsequent compliance dates within one year (or the operating cycle, if longer) after the balance sheet date. This guidance applies when a debtor would have violated a covenant as of the balance sheet date in the absence of a modification to the debt terms (i.e., a debt modification before the balance sheet date is treated as a waiver of a debt covenant under this guidance; see Section 13.5.2.3).

Example 13-5

Recurring Minimum Working Capital Requirement

The terms of a debt obligation require the debtor to maintain a minimum amount of working capital in each fiscal quarter. If the working capital requirement is not met, the creditor obtains the right to immediately accelerate the due date of the debt’s outstanding amount. The debtor violates the covenant as of December 31, 20X1. Further, the creditor waives its right to accelerate the due date of the debt as a result of the debtor’s violation of the covenant as of December 31, 20X1. However, the debtor retains its right to accelerate the debt’s due date if the covenant is not met as of March 31, 20X2. In this scenario, the debtor must consider the guidance in ASC 470-10-45-1.

Generally, a long-term obligation should be classified as noncurrent if the creditor has waived the specific covenant violation unless it is probable that the debtor will be unable to cure the violation on the compliance dates within the next 12 months (or the operating cycle, if longer) after the balance sheet date. If it is reasonably possible that the debtor will meet the same and more restrictive covenants on the subsequent compliance dates within the next 12 months (or the operating cycle, if longer) after the balance sheet date, the debt should be classified as noncurrent. However, the obligation should be classified as current if it is probable that debtor will be unable to meet the covenant on any of the subsequent compliance dates within the next 12 months (or the operating cycle, if longer) after the balance sheet date. In other words, the obligation should be classified as current if there is a remote likelihood that the debtor will meet the covenant on all subsequent compliance dates within the next 12 months (or the operating cycle, if longer) after the balance sheet date.

Note that the guidance on recurring covenant tests includes a different likelihood threshold for curing the covenant violation than the guidance on grace periods. For a debtor to justify noncurrent classification under the guidance on grace periods, curing the default must be probable (see Section 13.5.3.4), whereas it must merely not be probable that the debtor will be unable to cure the default under the guidance on recurring covenant tests.

ASC 470-10

Example 1: Classification of Long-Term Debt That Includes Covenants

55-2 This Example illustrates the guidance in paragraph 470-10-45-1 for the classification of long-term debt when a debt covenant violation is waived by a lender for a period greater than a year.

55-3 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. That violation gives the lender the right to call the debt. The lender waives that right for a period greater than one year but retains the future covenant requirements.

55-4 The issue is whether the waiver of the lender’s rights resulting from the violation of the covenant with the retention of the periodic covenant tests represents, in substance, a grace period. If viewed as a grace period, the borrower would classify the debt as current (see paragraph 470-10-45-11) unless it is probable that the borrower can cure the violation (comply with the covenant) within the grace period. Specifically, the balance sheet classification of an obligation is considered in the following situations:

The debt covenants are applicable only after the balance sheet date, and it is probable that the borrower will fail to meet the covenant requirement at the compliance date three months after the balance sheet date.
The borrower meets the current covenant requirement at the balance sheet date, and it is probable that the borrower will fail to meet the same covenant requirement at the compliance date in three months.
The borrower meets the current covenant requirement, and it is probable that the borrower will fail to meet a more restrictive covenant requirement applicable at the compliance date in three months.
The borrower has met the covenant requirement in the prior quarter but before the balance sheet date negotiates a modification of the loan agreement that eliminates the covenant requirement at the balance sheet date or modifies the requirement so that the borrower will comply. Absent the modification, the borrower would have been in violation of the covenant at the balance sheet date. The same or a more restrictive covenant must be met at the compliance date in three months, and it is probable that the borrower will fail to meet that requirement at that subsequent date.
The borrower is in violation of the current covenant requirement at the balance sheet date and, after the balance sheet date but before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25), obtains a waiver. The same or a more restrictive covenant must be met at the compliance date in three months, and it is probable that the borrower will fail to meet that requirement at that subsequent date.

55-5 In the situations described in (a) through (c) of the preceding paragraph, the debt would be classified as noncurrent, in which case the borrower would be required to disclose the adverse consequences of its probable failure to satisfy future covenants.

55-6 In the situations described in paragraph 470-10-55-4(d) through (e), the debt would be classified as current. However, if the debt is expected to be refinanced on a long-term basis and the borrower meets the provisions of paragraphs 470-10-45-13 through 45-20, the debt would be classified as noncurrent.

13.5.3.4 Grace Periods

ASC 470-10

b. 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, thus preventing the obligation from becoming callable.

Generally, long-term debt that has become payable on demand or within one year (or the operating cycle, if longer) after the balance sheet date because of a covenant violation is classified as current (see Section 13.5.1). However, if the debt agreement contains a grace period during which the debtor may cure the violation, the debtor classifies the debt as noncurrent if it is probable that the violation will be cured within the established grace period. To apply the exception in ASC 470-10-45-11(b) for grace periods, an entity must ensure that the violated provision is related to credit (see Section 13.3.4.5). For a discussion of the analysis of covenant violations that are not credit-related, see Section 13.4.3.

In determining whether it is probable that the violation will be cured within the contractual grace period, a debtor must use judgment and consider all relevant facts and circumstances. In the absence of persuasive evidence that it is probable that the debtor will be able to cure the violation before the end of the grace period, the obligation should be classified as current unless the debtor has obtained a covenant waiver that meets the requirements in ASC 470-10-45-11(a) (see Section 13.5.3.2) or the debtor has the intent and ability to refinance the obligation on a long-term basis (see Section 13.7). If a more than remote likelihood exists that the debtor will be unable to remedy the violation, the debt should be classified as current even if the debtor expects that the creditor will not demand repayment.

13.5.3.5 Comparison of Guidance on Covenant Waivers and Grace Periods

When a lender issues a covenant waiver, the related debt is classified as noncurrent unless it is probable that the debtor will violate the same or a more restrictive covenant again as of a measurement date that is within 12 months of the balance sheet date (see Section 13.5.3.3). By contrast, when a loan agreement contains a grace period, the related debt is classified as current unless it is probable that the debtor will cure the violation within the specified grace period, thus preventing the obligation from becoming repayable on demand (see Section 13.5.3.4). The decision tree below summarizes the guidance on classification of debt upon the violation of a covenant as of the balance sheet date.

Example 13-6

Failure to Satisfy Debt Covenant — No Grace Period Provided in Debt Agreement

Company A has a long-term loan that requires it to comply with certain covenants, including quarterly minimum quantitative ratios (e.g., a debt-to-equity ratio) and issuance of annual audited financial statements with an audit opinion that is not subject to any qualifications or exceptions with respect to the scope of the audit or any going-concern emphasis. Company A failed to meet the minimum quantitative ratio as of December 31, 20X1. Thus, the lender has the right to demand repayment of the debt immediately. The loan agreement does not specify a grace period for curing covenant violations.

Company A must classify the debt as current as of December 31, 20X1. When a loan agreement does not contain a grace period, long-term debt should be classified as current when a debtor is in violation of a loan covenant as of the balance sheet date since the obligation is repayable on demand by the lender.

Example 13-7

Failure to Satisfy Debt Covenant — Grace Period Provided in Debt Agreement

Assume the same facts as in the example above, except that the loan agreement contains a grace period during which the debtor can cure the violation. Company A would need to assess the probability of curing the covenant violation. Unless A determines that it is probable that the covenant violation will be cured within the specified grace period, current classification of the loan would be required.

Example 13-8

Failure to Satisfy Debt Covenant — Waiver Obtained by Debtor

Assume the same facts as in Example 13-6 except that the lender has waived its right to demand repayment of the loan related to the specific covenant violation for a period of more than 12 months after the balance sheet date. Company A would classify the debt as a current liability only if it is probable that it will violate the same or a more restrictive covenant again as of measurement dates that are within 12 months of the balance sheet date (see Section 13.5.3.3).

13.5.4 Disclosure

ASC 470-10

50-2 If an obligation under paragraph 470-10-45-11(b) is classified as a long-term liability (or, in the case of an unclassified balance sheet, is included as a long-term liability in the disclosure of debt maturities), the circumstances shall be disclosed.

SEC Regulation S-X, Rule 4-08

§210.4-08 General Notes to Financial Statements [Reproduced in ASC 235-10-S99-1]

If applicable to the person for which the financial statements are filed, the following shall be set forth on the face of the appropriate statement or in appropriately captioned notes. The information [required by paragraph (c)] shall be provided as of the most recent audited balance sheet being filed . . . . When specific statements are presented separately, the pertinent notes shall accompany such statements unless cross-referencing is appropriate. . . .

(c) Defaults. The facts and amounts concerning any default in principal, interest, sinking fund, or redemption provisions with respect to any issue of securities or credit agreements, or any breach of covenant of a related indenture or agreement, which default or breach existed at the date of the most recent balance sheet being filed and which has not been subsequently cured, shall be stated in the notes to the financial statements. If a default or breach exists but acceleration of the obligation has been waived for a stated period of time beyond the date of the most recent balance sheet being filed, state the amount of the obligation and the period of the waiver. . . .

Nonauthoritative AICPA Guidance

Technical Q&As Section 3200, “Long-Term Debt”

.17 Disclosure of Covenant Violation and Subsequent Bank Waiver

Inquiry — At the balance-sheet date, an entity was in violation of certain provisions of the loan covenant associated with its long-term debt. Under the terms of the loan agreement, the obligation is now callable by the creditor. Subsequent to the balance-sheet date, the bank waived its right to demand repayment for more than one year from the balance-sheet date. Therefore, the loan remained classified as long-term, per Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 470-10-45-12. Does the covenant violation and subsequent bank waiver need to be disclosed in the financial statements?

Reply — 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. If the lender has waived the right for greater than one year but retained the future covenant requirements (i.e., covenant requirements will have to be met at interim dates during the next 12 months), the accounting and disclosure provisions of FASB ASC 470, Debt, apply.

For SEC registrants, Regulations S-X, Article 4, Section 210-4-08(c), requires disclosure of the amount of the obligation and the period of waiver whenever a creditor has waived its right to call the debt for a stated period of time.

ASC 470-10-50-2 requires a debtor to disclose the circumstances in which it is in violation of a debt covenant but classifies the related debt as noncurrent because it is probable that the violation will be cured with a specified grace period that extends beyond the date on which the financial statements are to be issued (see Section 13.5.3.4). For example, it might be appropriate to disclose a description of the nature of the violation, the actions taken by the debtor to cure the violation, and a statement that it is probable that the violation will be cured before the end of the grace period. In addition, debtors that do not present a classified balance sheet and describe the obligation as a long-term liability must disclose this description in their discussion of debt maturities.

Further, SEC Regulation S-X, Rule 4-08, requires SEC registrants to disclose information about (1) the facts and amounts associated with any defaults or other covenant violations that existed as of the balance sheet date and that have not been subsequently cured and (2) the amount and the period of the waiver if a waiver of a default or covenant violation was given for a period beyond the balance sheet date. As discussed in AICPA Technical Q&As Section 3200.17, disclosure of covenant waivers and the waiver period “may be vital” also for users of financial statements of nonpublic entities.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.