Accounting for Debt – The Devil Is in the Details

Businesses take out debt obligations, including loans payable and bonds payable, for many reasons. It may be to purchase real estate, equipment, or inventory; expand operations; or increase working capital. Before debt obligations are obtained, it is important to understand the financial reporting implications.

This article explores some of the common accounting topics related to debt financing:  how to initially measure debt, accounting for debt issuance costs, debt covenants, presenting debt as either current or noncurrent, and other details that may be present in debt agreements.

Amount of Debt to Record

When a company takes out debt, the initial measurement of the debt to record is often the face value of the debt instrument. However, there are instances when this is not the case. When a note is issued solely for cash, it is presumed to have a present value at issuance measured by the amount of cash exchanged, unless there are some other rights or privileges received. In these cases, the value of the rights or privileges should be given accounting recognition by establishing a discount or premium. 

When a note is issued in exchange for property, goods, or services, the note’s stated interest rate is reasonable, and the face value of the note approximates the asset received, the amount of the liability recorded will equal the face value of the note. In cases when the note has no stated interest rate or an unreasonable one, or when the face value of the note materially differs from the cash sales price of the property obtained, the transaction should be valued at either the fair value of the property or the market rate of the note, whichever is more clearly determinable. The difference between the face value of the note and the exchange value of the transaction is to be recognized as a discount and amortized to interest expense over the life of the note using the effective interest method. 

In instances when the fair value of the property or note cannot be determined, the present value of the note is calculated by imputing interest. The rate at which the interest is imputed should approximate the rate a borrower and lender would agree on in an arm’s-length transaction.

Debt Issuance Costs (ASU 2015-03)

Costs associated with issuing debt obligations, such as fees and commissions, are referred to as debt issuance costs. There has been a change in the way these costs are reported, effective for financial statements issued for fiscal years beginning after December 15, 2015. 

Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) No. 2015-03, Interest – Imputation of Interest, has been issued and requires the presentation of debt issuance costs as a reduction of the carrying amount of the debt, whereas prior guidance indicated these costs should be reported as an asset. This change was issued because of FASB’s efforts to simplify GAAP and attempt to align more with International Financial Reporting Standards (IFRS). 

This update requires that debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the carrying amount of that debt liability, similar to debt discounts. These costs are amortized to interest expense over the term of the debt. The unamortized debt issuance costs should be disclosed as an offset to total debt in the debt footnote disclosure. When an entity transitions to this new guidance, it should apply the guidance on a retrospective basis and is required to comply with the applicable disclosures for a change in accounting principle.

Debt Covenants

Debt covenants are restriction clauses included in debt agreements that aim to protect the lender by restricting the activities of the borrower, and yet covenants can benefit both the lender and the borrower. The lender is protected by requiring or prohibiting certain activities that may be detrimental to said lender, and the borrower may benefit from a reduced cost of borrowing.

Debt covenants can be positive or negative. Positive debt covenants state what the borrower must do and include maintaining certain minimum financial ratios, maintaining accounting records in accordance with GAAP, providing audited financial statements within a specified period of time, or performing regular maintenance on real assets used as collateral. The most common financial ratios used in debt covenants include debt to cash flow, interest coverage, leverage, current, and debt to equity. 

Negative debt covenants state what the borrower cannot do and may include restrictions on incurring additional long-term debt, paying cash dividends in excess of certain thresholds, or selling certain assets. Violation of debt covenants that result in obligations being callable by the creditor affects the balance sheet classification of the obligation.

There are instances when debt agreements include a subjective acceleration clause, which states that the creditor may accelerate payment terms under conditions in which the criteria are subjective and not objectively determined. Such clauses could include the following examples:  “If the debtor fails to maintain satisfactory operations” or “if a material adverse change takes place.” Whether or not these subjective acceleration clauses have been violated is a decision made based on subjective information and not objective data. The next section will describe the financial statement presentation ramifications of subjective acceleration clauses.

When a loan covenant is not met, the consequences to the entity’s financial position can be very negative. Violation of a covenant may result in a default on the loan being declared, penalties being applied, and the debt being called (all outstanding debt being due and payable immediately). Since lenders can call the debt in these situations, the related debt often must be reported as current, as discussed in the next section. Because violations of covenants may create a state of default, it is imperative to understand the covenants that are included in your debt agreements and to carefully review and model out your compliance.

Reporting Debt as Either Current or Noncurrent   

Principal payments that are due within one year of the financial statement date (or operating cycle, if longer) are to be classified as current liabilities on the balance sheet. The current liability includes obligations that are due on demand or that will be due on demand within one year from the date of the financial statements (or operating cycle, if longer) even if payment may not be expected to be made within that period.

Determining the impact of debt covenant violations on financial statement presentation can be tricky. The current portion may include debt obligations with covenants that have been violated as of the financial statement date, resulting in the obligation being callable by the creditor within one year (or operating cycle, if longer) of the financial statement date. If at the date of the financial statements the debtor is in violation of a covenant of a debt agreement, the related debt must be considered current unless the creditor has waived the covenant violation or the violation is cured after the balance sheet date but prior to financial statement issuance.

Debt covenants often include a grace period. If the debtor is in violation of the covenant at the financial statement date, but it is probable that the debtor will cure the violation within the specified grace period, the debt should not be classified as current, since the debt is not callable from the covenant violation during the grace period. When the grace period expires before the financial statements are issued, the violation must be cured by that time in order for debt that is otherwise callable to be considered long term. In most situations, if a violation takes place after the balance sheet date but prior to the issuance of the statements, adjustment of the debt to current status is not required, but disclosure is necessary.

As described in the previous section, debt agreements may contain a debt covenant in the form of a subjective acceleration clause. Since these types of clauses are subjective, the borrower must consider the likelihood of the lender exercising its rights under such clauses in the following year (or operating cycle, if longer). If the borrower considers it and can support the fact that there is a remote likelihood the lender will exercise its right under such clauses in the following year, it is appropriate to classify the related debt as noncurrent. If the borrower considers it likely the lender will exercise its right to collect, it will need to be determined whether current financial statement classification of the debt and/or disclosure is appropriate, which will depend on the circumstances.

Devil Is in the Details

Other details that may significantly impact the accounting for the debt are often included in debt agreements, so it is imperative to review and understand your debt agreements. As an example, the contract may include a co-borrower under a joint and several debt agreement. Under this type of arrangement, all parties involved have an obligation to repay the loan, whether or not there is a default on the debt. An entity that is part of a joint and several debt agreement should initially recognize the obligation as the sum of the amount the entity agreed to pay under the arrangement among the co-obligors, plus an estimate of any additional amount the entity expects to pay on behalf of the entity’s co-obligors (either the best estimate or, if there is no best estimate, the minimum amount within a range of possible amounts).

Another example is that debt agreements may include a contract of guarantee, which another party, the guarantor, signs on behalf of the borrower. This is a promise to the lender that if the borrower defaults, the guarantor is obligated to pay the lender the amount owed by the borrower. There are two elements to a guarantee, the contingent element (the guarantor is contingently obligated to make future payments if triggering events or conditions occur), and the noncontingent element (the guarantor is obligated to stand ready to perform over the term of the guarantee in the event that the triggering events or conditions occur). The contingent element of a guarantee is to be accounted for following FASB ASC 450, Contingencies. That is, a guarantor discloses the guarantee agreement and records a liability for the guarantee only when it is probable that a loss has been incurred and the amount of the loss can be reasonably determined. However, many guarantors do not realize they incur a liability at the time they agree to the contract of guarantee, and they fail to account for the noncontingent element, as described in FASB ASC 460, Guarantees. Under this guidance, a guarantor may be required to recognize, at the inception of certain guarantees, a liability for the fair value of the obligation undertaken when the guarantee was issued. In other instances, no liability is required to be recorded, but disclosures are required to be made. These are a complicated set of standards; therefore, it is very important to understand the accounting implications of guarantees of debt and to review the terms of the guarantee to properly account for it.

Understand the Implications

Clearly, there are financial reporting implications related to debt obligations. The more you borrow, the more careful you need to be about making sure you understand the terms of debt agreements—in addition to the accounting requirements—so debt is properly reported in accordance with GAAP.