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Current or noncurrent? Getting debt classification right · PwC's accounting podcast

• 0:00
  SPEAKER_00: Thought Leadership from PWC's National Office.
• 0:07
  SPEAKER_02: Hello, and welcome to PwC's Accounting Podcast.
• 0:11
  SPEAKER_02: I'm Heather Horn.
• 0:13
  SPEAKER_02: Thanks for joining us today as we jump into current topics in accounting and reporting.
• 0:18
  SPEAKER_02: For today's discussion, I'm pleased to welcome guest host, Diana Stoltzfist, a partner in PWC's National Office and a podcast regular.
• 0:27
  SPEAKER_02: I'll hand it over to Diana for more details on today's episode.
• 0:35
  SPEAKER_04: Welcome to our mini-series on debt and financing transactions.
• 0:39
  SPEAKER_04: Today we're focusing on balance sheet classification of debt, specifically when debt should be classified as current versus non-current.
• 0:47
  SPEAKER_04: While that may sound straightforward, the accounting can become very judgmental in practice, particularly in the current economic environment as companies navigate covenant violations, refinancing activity, liquidity pressures, revolving credit facilities, and subjective acceleration clauses.
• 1:04
  SPEAKER_04: These judgments can also have significant implications for how investors, lenders, and other stakeholders view a company's financial position.
• 1:13
  SPEAKER_04: Joining me today are Chris Gerdo, a partner, and Suzanne Stefani, a director from PWC's National Office.
• 1:19
  SPEAKER_04: We're going to walk through some of the more challenging areas we're seeing in practice and discuss how companies should think about these classification questions.
• 1:27
  SPEAKER_04: Suzanne, let's start with the big picture.
• 1:29
  SPEAKER_04: I touched on it briefly, but why is debt classification so important?
• 1:34
  SPEAKER_03: Yeah, I guess when someone picks up a balance sheet, right?
• 1:37
  SPEAKER_03: One of the first things they're going to look at or think about is how much is in current liabilities?
• 1:44
  SPEAKER_03: What is the working capital?
• 1:45
  SPEAKER_03: What's the current ratio?
• 1:47
  SPEAKER_03: They're going to try to figure out other liquidity metrics, right?
• 1:50
  SPEAKER_03: All of those things, they're going to help the person looking at the financials get a picture of the company's liquidity and solvency.
• 1:58
  SPEAKER_03: Thinking about can this company pay their bills?
• 2:00
  SPEAKER_03: Will they be able to sustain the business?
• 2:02
  SPEAKER_03: And it's really driven off a lot of those metrics.
• 2:05
  SPEAKER_03: So debt classification can really impact those metrics.
• 2:09
  SPEAKER_03: If all of a sudden a large amount of debt goes from non-current to current for whatever reason, those metrics can completely change overnight.
• 2:18
  SPEAKER_03: And it's going to change how users think about the company.
• 2:22
  SPEAKER_03: So you mentioned some of them, Diana, like investors, banks, rating agencies, customers, suppliers.
• 2:27
  SPEAKER_03: It changes how they might look at that company.
• 2:30
  SPEAKER_03: And what that means is it can really affect the businesses itself.
• 2:33
  SPEAKER_03: You know, it impacts the company's ability to raise debt, issue equity, enter into new contracts, or even keep existing customers and suppliers feeling, you know, good about the company.
• 2:45
  SPEAKER_03: So really important.
• 2:47
  SPEAKER_03: And, you know, there's a lot of heightened awareness around this topic of debt classification because of that.
• 2:54
  SPEAKER_04: Right.
• 2:54
  SPEAKER_04: And I think, you know, given the current economic conditions too, where some companies are facing higher costs, rising interest rates, lots of those things, it can certainly have like a very broad impact and is very relevant today, as always.
• 3:06
  SPEAKER_04: But you know, this current environment added some additional challenges.
• 3:09
  SPEAKER_04: So maybe turning to you, Chris, maybe we can start with the basics.
• 3:14
  SPEAKER_04: When determining whether term debt should be classified as current or non-current, what are the key things companies need to evaluate?
• 3:21
  SPEAKER_01: Sure.
• 3:22
  SPEAKER_01: The uh starting point is thinking about what the contractual maturity is.
• 3:27
  SPEAKER_01: Um and so you look at the contractual maturity of the um principal payments, and if it's um whatever is due within 12 months, that'll be classified as current.
• 3:40
  SPEAKER_01: Um if what's greater than 12 months um would be non-current, and that's as of the balance sheet date.
• 3:47
  SPEAKER_01: Okay.
• 3:47
  SPEAKER_01: Um from there, you need to think about other terms that may be in the in the debt instrument.
• 3:54
  SPEAKER_01: Um, and so you know, oftentimes those are put options or call options.
• 3:59
  SPEAKER_01: You know, put option is when the lender has the right to demand payment at a different date than the final contractual maturity.
• 4:10
  SPEAKER_01: There's differences in how to think about that if it's a non-contingent put versus a contingent put.
• 4:15
  SPEAKER_01: And so a non-contingent put, uh, oftentimes they may be thought of as like time-based puts, it's you know, um, the lender has the right to demand payment at some point in the future.
• 4:27
  SPEAKER_01: Um if those puts are included in the debt instrument, you kind of move the maturity date from the final maturity to whatever that first put date is.
• 4:36
  SPEAKER_01: And now that's the decision point that you're looking at.
• 4:39
  SPEAKER_01: So if that first put date is within 12 months from the balance sheet date, um, then the debt would have to be current.
• 4:46
  SPEAKER_01: Um that would include um what's commonly referred to as due on demand, um, where do on demand debt is usually doesn't actually have a state of maturity date.
• 4:55
  SPEAKER_01: It's just whenever the lender wants, they can say um you owe me now.
• 4:59
  SPEAKER_04: Okay.
• 4:59
  SPEAKER_01: And so that's effectively like you know a evergreen put option, if you will.
• 5:04
  SPEAKER_01: And so it could be put tomorrow.
• 5:06
  SPEAKER_01: Um, and so therefore uh it would be current current, all that debt.
• 5:10
  SPEAKER_01: Exactly.
• 5:11
  SPEAKER_01: Um, but then I think about contingent put options, right?
• 5:14
  SPEAKER_01: And so a contingent put option is there's like a true contingency there, and I can't accelerate the debt as a lender unless some thing happens.
• 5:24
  SPEAKER_01: So common examples are like a change of control or a sale of certain assets and things like that.
• 5:30
  SPEAKER_01: So if one of those things happen, then I have the right to accelerate.
• 5:35
  SPEAKER_01: And so when you think about contingent puts, what you think about is what are the facts that exist as of the balance sheet date?
• 5:43
  SPEAKER_01: And so if the contingency would have been met as of the balance sheet date and then the put right exists, um, then it would be current.
• 5:51
  SPEAKER_01: Okay.
• 5:52
  SPEAKER_01: Assuming that that put is, you know, within the 12 months, right?
• 5:54
  SPEAKER_01: Right.
• 5:55
  SPEAKER_01: Uh but if the facts don't exist at the balance sheet date, if the contingency would not have been met as of the balance sheet date, uh, then there was no contractual right to put the debt at that point in time.
• 6:06
  SPEAKER_01: And so you would leave it based on whatever the terms or the rest of the terms would say would would say it is.
• 6:12
  SPEAKER_01: And then the next thing that you think about is uh something that's called subjective acceleration clauses.
• 6:18
  SPEAKER_01: And so what the subjective acceleration clause does is it gives the lender some subjectivity to accelerate payments that are due.
• 6:27
  SPEAKER_01: Um and it's not based off of like truly objectable or objective um measurable um terms.
• 6:34
  SPEAKER_01: It's okay, something that's going to be judgmental.
• 6:38
  SPEAKER_01: Um and you know, when you're thinking about this, it's not like if I'm looking at a debt agreement, there's going to be a big headline that says, here's your subjective acceleration clause.
• 6:46
  SPEAKER_01: Here they are.
• 6:47
  SPEAKER_01: Exactly.
• 6:47
  SPEAKER_01: Right.
• 6:47
  SPEAKER_01: Unfortunately, the contracts aren't written out that way.
• 6:50
  SPEAKER_01: That makes our life extremely easy in the county.
• 6:52
  SPEAKER_04: Right.
• 6:53
  SPEAKER_01: But um what you might see is like, you know, if there's a material adverse change, uh, then then the lender has the right to accelerate payment.
• 7:03
  SPEAKER_01: Um, or if there's been an unsatisfactory financial condition, uh then the lender can accelerate payment.
• 7:10
  SPEAKER_01: Or if there's been a material deterioration in the quality of assets or collateral or you know, a material change in revenue.
• 7:18
  SPEAKER_01: You know, something like that, right?
• 7:19
  SPEAKER_01: Something that's not you know black and white, where I've said if it changes by this exact amount, it's just more like material, you know, unsatisfactory things like that.
• 7:28
  SPEAKER_04: So a lot of judgment in determines a lot of judgment, right?
• 7:31
  SPEAKER_01: So you may, as the borrower, think, oh, that's not a material adverse change, but the lender may, and so now it's who's right.
• 7:39
  SPEAKER_01: Um but anyway, um in ASC 470, there's specific guidance in how to think about subjective acceleration clauses.
• 7:47
  SPEAKER_01: Um and you know, there's like two or three possibilities.
• 7:50
  SPEAKER_01: So if it's probable that an accepted uh subjective acceleration clause, those it's hard to say three times fast, right?
• 8:00
  SPEAKER_01: Uh if it's probable that a subjective acceleration clause um will get exercised within the 12 next 12 months, um, then it would have to be presented as current.
• 8:11
  SPEAKER_01: If it's not probable, um, but it's reasonably possible that it could be exercised in the next 12 months, um, then you would have to disclose that that fact.
• 8:22
  SPEAKER_01: But if it's remote um that it would get exercised, um then there's nothing that you have to do.
• 8:27
  SPEAKER_01: Okay.
• 8:27
  SPEAKER_01: Um, although you always have to think about should I be disclosing material terms of my debt anyway.
• 8:32
  SPEAKER_01: So um that's a different consideration, but in terms of specific for the 470 guidance around subjective acceleration clauses, those are kind of the decision points.
• 8:42
  SPEAKER_04: Okay.
• 8:43
  SPEAKER_04: Well, that's helpful.
• 8:44
  SPEAKER_04: There's clearly a lot of judgment that needs to be made then and just this determination and making sure that you're identifying all the terms in the agreements as well, especially when companies are facing liquidity or operating challenges.
• 8:56
  SPEAKER_03: Hey, Diana, I just wanted to jump in here real quick while we're talking about these clauses because the FASBE just added a project that's gonna look at these clauses and their impact on debt classification.
• 9:08
  SPEAKER_03: So they talked about this at their 527 board meeting.
• 9:13
  SPEAKER_03: And I only want to mention it now.
• 9:15
  SPEAKER_03: I mean, the guidance that Chris talked about is still in effect, and that's what we're following.
• 9:20
  SPEAKER_03: But this could really impact debt classification in the future.
• 9:24
  SPEAKER_03: It's it's still in the early project stages, but it looks like they're considering a model where this probability assessment won't have to be done, but rather it's gonna focus on when the subjective acceleration clause is actually triggered.
• 9:39
  SPEAKER_03: So you don't have to look at probability.
• 9:41
  SPEAKER_03: So stay tuned on this.
• 9:42
  SPEAKER_04: Okay.
• 9:43
  SPEAKER_04: Well, that's helpful.
• 9:44
  SPEAKER_04: So, Chris, you mentioned that we need to think about all these call options differently from put options.
• 9:49
  SPEAKER_04: So, Suzanne, how do call options impact debt classification?
• 9:54
  SPEAKER_03: Yeah, so when we say call option, because sometimes there's some confusion on what a call or a put is, depending on what side you're on.
• 10:02
  SPEAKER_03: So we're on the um borrower side here.
• 10:05
  SPEAKER_03: So a call option, it's a prepayment option, right?
• 10:09
  SPEAKER_03: The borrower can decide if they want to prepay the debt early.
• 10:14
  SPEAKER_03: So it's something that's in the borrower's control.
• 10:17
  SPEAKER_03: So that's what we're saying when we say call option.
• 10:20
  SPEAKER_03: Um, so when you're thinking about how those impact classification as current or non-current, there's been some diversity in practice here.
• 10:28
  SPEAKER_03: And it kind of stems back to how companies interpret the definition of a current liability.
• 10:34
  SPEAKER_03: It's in ASC 210.
• 10:36
  SPEAKER_03: So the definition of a current liability is something that's I'm paraphrasing that, something that's reasonably expected to require the use of current assets or creation of another current liability.
• 10:49
  SPEAKER_03: So there is some, and I'll get into it kind of two ways people think about that.
• 10:54
  SPEAKER_03: One view focuses around requirement, the word requirement, and the other view focuses around the word expectations.
• 11:02
  SPEAKER_03: So if I give you um a quick example, I have long-term debt, immatures in like five years, but the borrower has a prepayment option at any time, it can prepay the debt.
• 11:12
  SPEAKER_03: And let's just say, you know, we're at the Q2 balance sheet date, and the borrower knows, like they fully expect that they're gonna prepay this debt two months later.
• 11:23
  SPEAKER_03: Okay, in Q3, August, something you can't do the math.
• 11:27
  SPEAKER_03: Um, should the debt be current or non-current?
• 11:29
  SPEAKER_03: Because we know it's gonna be repaid with cash, right?
• 11:32
  SPEAKER_03: Very soon.
• 11:33
  SPEAKER_03: Um, the first view, and this has been our longstanding view for for for uh quite a while, is to focus on the word requirement.
• 11:40
  SPEAKER_03: Is there anything at Q2 in my example that requires that company to pay off the debt?
• 11:46
  SPEAKER_03: And the answer is no, right?
• 11:48
  SPEAKER_03: It's just their option.
• 11:49
  SPEAKER_03: So, in that case, following that view, the debt is non-current because there's no contractual requirement to repay.
• 11:56
  SPEAKER_03: Um, there is an alternative view out there in practice that focuses on reasonable expectations.
• 12:02
  SPEAKER_03: So, under that view, the debt would be current because the borrower reasonably expects to pay it in a couple of months from the balance sheet date.
• 12:11
  SPEAKER_03: And they say the bit they're gonna use cash, cash on hand, current assets to repay it.
• 12:16
  SPEAKER_03: So, following that view, the debt would be current.
• 12:19
  SPEAKER_03: So I'd say given the diversity in practice here, people may have already, you know, chosen their policy, but we think this alternative view is acceptable.
• 12:27
  SPEAKER_03: But again, it's uh it's gonna be an entity-wide policy choice that's applied consistently.
• 12:32
  SPEAKER_04: Right.
• 12:32
  SPEAKER_04: So you couldn't pick and choose which one you want to apply depending on the different debt.
• 12:36
  SPEAKER_03: Right.
• 12:37
  SPEAKER_04: Okay.
• 12:37
  SPEAKER_04: So that's the basics for term debt.
• 12:40
  SPEAKER_04: Let's move into covenant violation because that's often where classification analysis becomes a little bit more complicated.
• 12:47
  SPEAKER_04: It's probably helpful to talk through a couple examples.
• 12:50
  SPEAKER_04: So, Suzanne, do you want to start out with one?
• 12:52
  SPEAKER_03: Yeah, and I think it is good to talk about now with different liquidity issues and things.
• 12:56
  SPEAKER_03: We're seeing a little bit more um like pressure on covenants and possibly violations.
• 13:01
  SPEAKER_03: So good to think about uh for Q2 here.
• 13:03
  SPEAKER_03: So let's say we have contractually long-term debt again, due in five years, and the debt has quarterly covenants, financial covenants.
• 13:12
  SPEAKER_03: And let's say at Q2 at the balance sheet date, the company fails um some sort of minimum working capital covenant.
• 13:20
  SPEAKER_03: So they are actually in default at the balance sheet date.
• 13:23
  SPEAKER_03: Okay.
• 13:24
  SPEAKER_03: But let's say after the balance sheet date, the company gets um gets a waiver of the violation.
• 13:29
  SPEAKER_03: Should the debt be current or non-current?
• 13:31
  SPEAKER_03: Because it was in default at the balance sheet date, but let's say they got they got a waiver.
• 13:35
  SPEAKER_03: Um the answer is depends.
• 13:37
  SPEAKER_03: And it's just, it's not automatically non-current because we got a waiver.
• 13:42
  SPEAKER_03: There's two things that the guidance gives us to think about.
• 13:44
  SPEAKER_03: One is look at the waiver itself.
• 13:47
  SPEAKER_03: Okay.
• 13:47
  SPEAKER_03: It has to be a long-term waiver, meaning the lender has to give up its right to force repayment for that violation, that Q2 violation, for at least 12 months from the balance sheet date.
• 13:57
  SPEAKER_03: So normally, though, usually they're going to waive the right for that one particular violation in Q2?
• 14:04
  SPEAKER_03: Indefinitely, right?
• 14:05
  SPEAKER_03: There's okay, okay, we we forgive that default.
• 14:08
  SPEAKER_03: The next step.
• 14:09
  SPEAKER_03: So if you got your long-term, let's assume you have your long-term waiver, the next step is a probability assessment.
• 14:14
  SPEAKER_03: You have to ask yourself, is it probable that the borrower will fail that same working capital ratio or a more restrictive covenant in 12 months following the Q2 balance sheet date in my example?
• 14:27
  SPEAKER_03: Um, so in my example, the covenants are quarterly.
• 14:30
  SPEAKER_03: So we're, so that same working capital ratio is coming back in Q3.
• 14:34
  SPEAKER_03: So they have to look and say, am I gonna fail it in Q3 or not?
• 14:38
  SPEAKER_03: And actually look out the next four quarters from Q2.
• 14:41
  SPEAKER_03: Um, and if it's probable they're gonna fail, then the debt still has to be current despite the waiver.
• 14:48
  SPEAKER_04: Even though they have the waiver for that covered violation, even though it's indefinite.
• 14:52
  SPEAKER_03: Right.
• 14:53
  SPEAKER_03: Because if I'm assuming those covenants are still there and you still have to meet them.
• 14:57
  SPEAKER_03: And if if you're gonna fail them again in the next four quarters, then that would be current.
• 15:03
  SPEAKER_03: Um, but if you can say it's reasonably possible that they will be met, then non-current is what you should do with disclosure of the circumstances.
• 15:12
  SPEAKER_03: Um now, more common though, like in this example, when the company goes to get the waiver, they're likely gonna know they're gonna meet that same covenant again in the future, like in Q3 and Q4.
• 15:23
  SPEAKER_03: So often what we see is they'll go to the lender, ask for the waiver, but then say, look, I I'm not I'm not making this covenant for the next couple of quarters.
• 15:32
  SPEAKER_03: So I need to amend this agreement.
• 15:35
  SPEAKER_03: So normally they might get a covenant holiday so they don't even have to meet that covenant for a certain period of time, or they might get less restrictive covenants that they know they're going to meet.
• 15:47
  SPEAKER_03: Okay.
• 15:48
  SPEAKER_03: Um, just so they don't have to keep going through this, right?
• 15:50
  SPEAKER_03: So when you're doing this probability assessment, you would look at these amended covenants to figure out if it's probable you're gonna fail.
• 15:58
  SPEAKER_03: So often, since they're already negotiating these easier covenants that they know they're gonna meet, they'll get to non-current.
• 16:05
  SPEAKER_03: But it really depends kind of on how everything is negotiated.
• 16:09
  SPEAKER_04: Right.
• 16:10
  SPEAKER_04: Okay.
• 16:10
  SPEAKER_04: So we've been talking about covenant violations that existed at the balance sheet date.
• 16:16
  SPEAKER_04: So maybe if we change the fact pattern slightly and we assume that a company knows before the end of the quarter that it's going to fail the covenant, but before the balance sheet date, they work with their lender to amend the agreement and make sure that the covenants, as you said, are easier to meet.
• 16:34
  SPEAKER_04: Then at the balance sheet date, the company complies with this new amended covenant.
• 16:39
  SPEAKER_04: So they're not at default as of the balance sheet date.
• 16:42
  SPEAKER_04: How does that impact the classification?
• 16:45
  SPEAKER_03: Yeah.
• 16:45
  SPEAKER_03: So so at Q2 balance sheet date, in my example, they're not in default, right?
• 16:50
  SPEAKER_03: Because they amended the covenants.
• 16:52
  SPEAKER_03: Um, the guidance that I talked about for waivers, though, it still needs to be thought about for this scenario as well.
• 16:58
  SPEAKER_03: Because the guidance kind of treats this pre-balance sheet date modification as essentially it's the same thing as a waiver.
• 17:05
  SPEAKER_03: You just did it in advance.
• 17:06
  SPEAKER_03: Right.
• 17:07
  SPEAKER_03: So why should you get a different answer?
• 17:09
  SPEAKER_03: You know, but to my point earlier, you're probably going to amend those covenants so they're easier to meet.
• 17:14
  SPEAKER_03: So you probably would get to non-current, but you have to disclose it and go through all those.
• 17:19
  SPEAKER_04: Okay.
• 17:19
  SPEAKER_04: But then you would do the analysis to say for then, you know, the next 12 months out, do I meet these amended covenants?
• 17:26
  SPEAKER_04: And so then if so, you would get to non-current.
• 17:28
  SPEAKER_04: Right, right.
• 17:29
  SPEAKER_04: Okay.
• 17:30
  SPEAKER_04: So maybe one more variation on this example.
• 17:33
  SPEAKER_04: Um, and Chris, I'll turn to you on this.
• 17:36
  SPEAKER_04: So let's assume that the company is actually in compliance with the covenant at the balance sheet date, but based on its forecasts and other things that it knows about it, you know, its expectations about its business performance, it thinks that it's going to fail the covenant during the upcoming quarter.
• 17:53
  SPEAKER_04: How does that affect the classification analysis?
• 17:56
  SPEAKER_01: Sure.
• 17:57
  SPEAKER_01: You usually start with uh, you know, what are the facts and circumstances as of the balance sheet date?
• 18:03
  SPEAKER_01: Okay.
• 18:03
  SPEAKER_01: Um, and so unlike the examples that Suzanne has been talking about, um, here the facts are different in that there was no violation or expected violation um for which there was an amendment or a waiver before the balance sheet date.
• 18:19
  SPEAKER_01: Um we were we were meeting our covenant violations and we didn't need to get any sort of waiver or an amendment to do so.
• 18:26
  SPEAKER_01: Um but then subsequent to the balance sheet date, we are coming up against covenants that um we either have or expect to to fail.
• 18:35
  SPEAKER_01: So we think about as of the balance sheet date, um, we were still okay, and so non-current um would be still appropriate in that circumstance.
• 18:45
  SPEAKER_01: Obviously, you would need to think about um disclosing the fact that uh, you know, especially if I violated the covenant, um, you know, along with um what adverse impacts um that may or may not have.
• 18:59
  SPEAKER_01: Now, there is some language in 470 that would say non-current is appropriate unless facts and circumstances dictate otherwise.
• 19:08
  SPEAKER_01: And so you could think about um, you know, facts and circumstances may dictate that current would be the more appropriate um presentation there, but we don't typically see companies um looking at that unless there are extenuating circumstances.
• 19:25
  SPEAKER_04: Okay.
• 19:26
  SPEAKER_04: Okay, that's helpful.
• 19:27
  SPEAKER_04: Okay, maybe one final covenant-related example, which may be more relevant for companies if they're facing more significant liquidity challenges.
• 19:37
  SPEAKER_04: So if a company gets an audit opinion with an emphasis of a matter paragraph related to its ability to continue as a going concern in its annual financial statements.
• 19:48
  SPEAKER_04: So getting this type of opinion could be considered an event of default in the debt.
• 19:54
  SPEAKER_04: How does that impact the classification analysis, Chris?
• 19:59
  SPEAKER_01: Yeah, so this actually comes up quite often where there is a going concern uh potential that will be issued uh in conjunction with the issuance of the financial statements.
• 20:12
  SPEAKER_01: And so technically the violation has occurred after the balance sheet date.
• 20:16
  SPEAKER_01: And so um one may think that everything that I just say would say that non-current is is the right answer.
• 20:23
  SPEAKER_01: And it still could be.
• 20:24
  SPEAKER_01: Um but you know, we talked earlier about subject subjective acceleration clauses, and you you made me say that again, didn't you?
• 20:31
  SPEAKER_04: Yes.
• 20:33
  SPEAKER_01: So um so we talked earlier about you know the subjective acceleration clauses.
• 20:37
  SPEAKER_01: And so if you think about some of the things that you know I said could be a subjective acceleration clause, you know, a material adverse change, right?
• 20:45
  SPEAKER_01: So one might say a going concern is a material adverse change, right?
• 20:50
  SPEAKER_01: And so that could then say that it's now probable that I would uh have a uh one of those clauses um be exercised.
• 20:58
  SPEAKER_01: And as we talked about before, that would say then it would need to be current.
• 21:01
  SPEAKER_01: So um the the presence of of a subjective acceleration clause could impact uh the considerations there.
• 21:08
  SPEAKER_04: Right.
• 21:08
  SPEAKER_04: Because you're really thinking about like what what's causing this going concern, then is it also meeting that trigger within the subjective acceleration clause?
• 21:16
  SPEAKER_01: Correct.
• 21:17
  SPEAKER_04: Okay, so maybe shifting gears from covenant violations to another area that can impact classification is the refinancing of short-term debt after the balance sheet date.
• 21:30
  SPEAKER_04: So maybe we'll walk through another example here and we'll assume that a company has debt that's contractually due three months after the balance sheet date.
• 21:39
  SPEAKER_04: So at the quarter end, it would normally be classified as short term.
• 21:43
  SPEAKER_04: Then after the balance sheet date, but before the financial statements are issued, the company issues new long term debt and uses those proceeds to pay off the short term obligation.
• 21:56
  SPEAKER_04: Does this refinancing impact the classification?
• 22:00
  SPEAKER_04: Of the short-term debt at the balance sheet date?
• 22:03
  SPEAKER_03: Yeah.
• 22:03
  SPEAKER_03: So if we have contractually short-term debt at the balance sheet date, it should in fact be classified as non-current if a company has the intent and ability to refinance on a long-term basis.
• 22:14
  SPEAKER_03: So there's two ways to do this.
• 22:16
  SPEAKER_03: There can be a long-term issuance of debt or equity after the balance sheet date, but before the financials are issued or through a financing agreement.
• 22:24
  SPEAKER_03: So in your example, Diana, the short-term debt at Q2, it actually must be classified as non-current because the company actually issued long-term debt before the financials were issued and used those prices to fully pay off the short-term debt.
• 22:39
  SPEAKER_03: So it has to be non-current.
• 22:42
  SPEAKER_03: And then the company would put it in non-current, but they would fully disclose the refinancing.
• 22:48
  SPEAKER_03: So the fine the user really understands what happened and why that short-term debt is in non-current.
• 22:54
  SPEAKER_04: Okay.
• 22:54
  SPEAKER_04: That makes sense.
• 22:56
  SPEAKER_04: Maybe if we tweak the fact pattern a little bit, and instead of the company actually refinancing the short-term debt after the balance sheet with contractually long-term debt, let's assume the company has an existing long-term revolving credit facility that is ultimately due in five years, and there's sufficient unused capacity on that revolving credit facility to pay down that short-term debt.
• 23:23
  SPEAKER_04: And so the company asserts that it intends to draw on that revolver and to repay the short-term debt when it becomes due.
• 23:31
  SPEAKER_04: How does that impact the classification analysis?
• 23:34
  SPEAKER_03: Yeah.
• 23:35
  SPEAKER_03: So this is trying to use assert that a company has the intent and ability to refinance using a financing agreement.
• 23:43
  SPEAKER_03: The classification depends, but you usually most companies can't get to non-current with an unfunded financing agreement.
• 23:52
  SPEAKER_03: And the reason is the guidance gives very specific conditions that the financing agreement has to meet in order to get contractually short-term debt to non-current.
• 24:03
  SPEAKER_03: So the agreement obviously has to be a long term.
• 24:06
  SPEAKER_03: There's no violation of covenants.
• 24:08
  SPEAKER_03: That's easy.
• 24:09
  SPEAKER_03: But there's there's something that says it can't be canceled.
• 24:13
  SPEAKER_03: The financing agreement can't be canceled for any subjective reasons.
• 24:18
  SPEAKER_03: And so this is back to the subjective acceleration cross that Chris was talking about.
• 24:23
  SPEAKER_03: Here, there's no um determination of if it's likely that the subjective acceleration clause will be exercised or anything.
• 24:31
  SPEAKER_03: It's just if you have one in your financing agreement, it's you're done.
• 24:36
  SPEAKER_03: You cannot use it to get contractually short-term debt to non-current.
• 24:40
  SPEAKER_03: And it's really common in these financing agreements to see some sort of SAC, right?
• 24:47
  SPEAKER_03: You might be like when you go to borrow on the financing agreement, a company might have to make a representation that there's been no material adverse change in the business since a certain date or something like that.
• 24:58
  SPEAKER_03: Super, super common.
• 25:00
  SPEAKER_03: So if the financing agreement has anything like that, then they can't assert company can't assert they have the ability to use the financing agreement to get to non-current.
• 25:09
  SPEAKER_03: Um, so you really have to dig through your agreements because often when I talk to someone, they'll say, No, we don't have that.
• 25:15
  SPEAKER_03: Like when you go through and really dig in, because Chris said this earlier, like it doesn't just like it's not just labeled that way, right?
• 25:22
  SPEAKER_04: You really have to read read through the individual terms, right?
• 25:25
  SPEAKER_03: Yep.
• 25:26
  SPEAKER_04: Okay.
• 25:26
  SPEAKER_04: So it's interesting too because these uh subjective acceleration clauses act differently depending on whether you're in long-term debt or this, you know, financing arrangement and that the how they impact the classification can vary as to whether or not you need to look at the probability or just even their existence can impact the classification.
• 25:45
  SPEAKER_04: So it's interesting.
• 25:47
  SPEAKER_03: But one last thing in this area, I mentioned earlier that the FASV met in May to discuss subjective acceleration clauses.
• 25:54
  SPEAKER_03: Well, this area with the financing agreements and SACs, it's also going to be looked at and could significantly change how they impact classification in the future.
• 26:04
  SPEAKER_03: So stay tuned in this area too.
• 26:06
  SPEAKER_04: Okay.
• 26:07
  SPEAKER_04: So maybe as we wrap up with maybe wrapping up with revolving debt arrangements, I know there's some unique classification considerations as well.
• 26:15
  SPEAKER_04: Chris, can you walk us through the basics?
• 26:18
  SPEAKER_01: Sure.
• 26:18
  SPEAKER_01: So as we've been talking about, you know, these financing arrangements and um when you have the ability to draw um on a line of credit, you know, a lot of times you can draw, repay, draw again.
• 26:31
  SPEAKER_01: So, like as I need cash, I draw down on it.
• 26:33
  SPEAKER_01: If I have some excess cash, I'll pay it down.
• 26:36
  SPEAKER_01: And that's kind of the revolving nature, and and hence the name revolvers.
• 26:40
  SPEAKER_01: Um, and so most of the times when I draw down on a revolver, I have no specific requirement to pay it back at a specific point in time, other than the contractual maturity of the overall line, which is usually going to be on a longer term basis.
• 26:57
  SPEAKER_01: Um, and so most of the times um you know that could be non-current.
• 27:03
  SPEAKER_01: There are some special twists though to thinking about revolvers.
• 27:08
  SPEAKER_01: Um, so a common one is uh lock boxes.
• 27:12
  SPEAKER_01: Um and so what a lockbox is is you know, think about like a you know a company that has a lot of retail customers and that you know, as you collect, you know, your your your sales or whatever, you know, your accounts receivable, instead of coming to you directly, it goes to this like lockbox.
• 27:30
  SPEAKER_01: And and so um the lender, you know, may control that lockbox and you know facilitates the payments for you.
• 27:37
  SPEAKER_01: Um, but then you need to think about well, what happens once that cash goes into that into that lockbox.
• 27:44
  SPEAKER_01: Um and so if customer receipts that are received automatically pay down the debt, um then it's inherently a short-term debt instrument because now there is sort of a requirement.
• 27:58
  SPEAKER_01: Um and you think about what the general guidance is in classified balance sheets in ASC 210 um definition of current liability um includes that if it's required to be repaid with working capital.
• 28:12
  SPEAKER_01: And so obviously your your cash that you're receiving from your customers is your working capital, and if it's being required to pay it down, then it would be current liability.
• 28:21
  SPEAKER_01: Um obviously, you know, Suzanne just talked about refinancing on a long-term basis, and so, well, I have the line of credit anyway, so I'll just redraw it.
• 28:30
  SPEAKER_01: So therefore I'm I'm good, right?
• 28:31
  SPEAKER_01: Right.
• 28:32
  SPEAKER_01: And but as she talked about, you know, most of them have the the subjective acceleration clause.
• 28:37
  SPEAKER_01: And so that kind of trumps uh all that.
• 28:41
  SPEAKER_01: And and so um you can't really point to the fact that I have a revolver to say that I can refinance on a long-term basis.
• 28:49
  SPEAKER_01: Um, but then we have something that's called a springing lockbox.
• 28:52
  SPEAKER_01: And a springing lockbox is I still may use that, you know, lender or that lockbox to collect all my payments and facilitate that for me.
• 29:00
  SPEAKER_01: Um, but that it's not automatically used to pay down debt.
• 29:04
  SPEAKER_01: It's only can be tapped into by the lender should I default on the debt.
• 29:08
  SPEAKER_01: And then they have the right to use the proceeds from the from the lockbox to automatically pay down.
• 29:13
  SPEAKER_01: Um, and so if that's the case, there's no impact to the classification unless I've actually had a default.
• 29:19
  SPEAKER_04: Okay.
• 29:20
  SPEAKER_04: Maybe just one question on clarifying with the the revolving debt arrangements and like the long-term debt when we're talking about the subjective acceleration clauses.
• 29:29
  SPEAKER_04: For the existence of the subjective acceleration clause in the revolving debt, it's only like if it exists in that that it like prevents you if you're refinancing a short-term debt.
• 29:39
  SPEAKER_04: But like for the revolving in and of itself, you would then look at the probability.
• 29:44
  SPEAKER_04: Is that right?
• 29:45
  SPEAKER_04: Just like a little bit of a nuance.
• 29:47
  SPEAKER_01: Well, think about it this way.
• 29:49
  SPEAKER_01: You know, if I've already have borrowed the funds, right, then I consider the probability of whether a SAC will get um exercised or a possibility, right?
• 29:59
  SPEAKER_01: But if I still need to borrow the funds, that's when it kind of prevents you from saying I can use those funds to refinance an existing short term into a long term.
• 30:09
  SPEAKER_04: Okay.
• 30:09
  SPEAKER_04: That's super helpful.
• 30:11
  SPEAKER_04: So, Suzanne, what are some situations where the revolving debt agreement is long-term, but each draw requires the execution of a separate note?
• 30:22
  SPEAKER_03: Yeah.
• 30:23
  SPEAKER_03: So sometimes we see this where you might have this long-term revolving debt financing agreement.
• 30:30
  SPEAKER_03: But each draw, each time you draw, it's really the execution of a separate note.
• 30:35
  SPEAKER_03: So if each draw requires a separate note, you look to the maturity date of that individual note for classification.
• 30:43
  SPEAKER_03: So if that individual note is due less than one year from the balance sheet date, that draw, that borrowing, that liability would be current in most cases.
• 30:53
  SPEAKER_03: Um it's really the same concept as the required lock box in a way.
• 30:58
  SPEAKER_03: It's it's short term because of the note.
• 31:00
  SPEAKER_03: And then you have to see if there's an attempt and ability to refinance that that debt on a long-term basis using the overall financing agreement.
• 31:08
  SPEAKER_03: But just like we said in the lockbox, you usually can't because you have subjective acceleration clause.
• 31:13
  SPEAKER_03: Um, but there's just one point where on this topic of, you know, revolvers and individual notes for draws.
• 31:21
  SPEAKER_03: I want to bring up one thing that sometimes um can be a little bit confusing to determine if your your revolving agreement is requiring you to have a separate note for each draw.
• 31:33
  SPEAKER_03: Um, I've seen this come up in practice every once in a while, where the company will have some sort of revolving debt arrangement that's long term, expires in say three years or something.
• 31:44
  SPEAKER_03: Every time the company draws, they can choose between a base rate borrowing, which is usually has an interest rate term that's consistent with the entire revolving debt arrangement, so three years in my example, or they can pick a sofa loan.
• 32:00
  SPEAKER_03: And when they pick a sofa loan, they can elect an interest rate term of one, two, three months, you know, what whatever they choose.
• 32:07
  SPEAKER_03: And if they choose that short-term sofa option, once the interest rate term expires, they have to elect a new rate option.
• 32:14
  SPEAKER_03: And often if for some reason they don't make the election, it'll it'll default to the base rate.
• 32:20
  SPEAKER_03: So in these cases, um, the company isn't usually required to repay that draw, even if it picks the shorter sofa option.
• 32:28
  SPEAKER_03: Um, the maturity date of the draws is usually the longer um date where the revolving agreement itself expires.
• 32:36
  SPEAKER_03: So it's three years in my example.
• 32:38
  SPEAKER_03: So what we see is sometimes companies see that sofa loan as like a short-term borrowing, you know, like you took a sofa loan for one month, they say, oh, it's it's like it has a separate note for one month and it has to be current.
• 32:54
  SPEAKER_03: But if you sometimes, when you really dig into the agreement, you see it's not a loan at all.
• 33:00
  SPEAKER_03: It's not an individual note, it's just something that the interest rate resets on.
• 33:04
  SPEAKER_04: It's really just how you determine the interest rate versus determining the maturity of the instrument overall.
• 33:09
  SPEAKER_03: Yeah.
• 33:09
  SPEAKER_03: So if you have something like that going on in your agreement, just kind of look at it and see, because usually it'll say when the actual draw itself is due to be repaid.
• 33:19
  SPEAKER_04: Okay.
• 33:19
  SPEAKER_04: Well, we've covered a lot of different scenarios today.
• 33:22
  SPEAKER_04: And I think one thing that stands out to me at least is there's a lot of different facts and circumstances, and that the individual clauses that are contained within the debt agreements are really important to understand.
• 33:34
  SPEAKER_04: So maybe as a final takeaway, I'll turn to each of you is what are some practical advice, Chris, that you would give companies as they think about evaluating the debt classification, particularly in the current environment?
• 33:47
  SPEAKER_01: Yeah, well, you you sort of hit on it, um, Diana, is you know, make sure you understand what all the terms are.
• 33:54
  SPEAKER_01: You know, uh, as we said often, you know, kind of the starting point is the contractual nature and the contractual maturity, but don't just simply look at if I've issued a five-year bond, then it's definitely you know, non-current is definitely long term.
• 34:09
  SPEAKER_01: That may have puts, they may have other clauses in there.
• 34:13
  SPEAKER_01: Um, and so make sure I understand all the terms that are in my agreements so that I can do a proper assessment on the classification.
• 34:19
  SPEAKER_04: Right.
• 34:20
  SPEAKER_04: And I guess it goes back to one of the things that's always important is understanding, like, you know, what's going on with the company overall and what what's happening with them and you know, could be creating different situations that could impact these different clauses as well.
• 34:32
  SPEAKER_03: Suzanne, um, yeah, I guess right now, you know, we're getting towards the end of Q2 and companies are kind of finalizing the numbers and going through their covenant calculations.
• 34:42
  SPEAKER_03: I think um it's really good to just understand um how the covenant guidance works, right?
• 34:48
  SPEAKER_03: To get to current or non-current.
• 34:50
  SPEAKER_03: So really have a good appreciation for that.
• 34:52
  SPEAKER_03: So you know that before you go in, if if you're in a situation where you're gonna have a covenant violation, before you go in and speak to your bank about getting a waiver, make sure you know what you need to have to be able to get to non-current classification and and then work to get that if you can.
• 35:08
  SPEAKER_03: And hopefully you can.
• 35:09
  SPEAKER_03: You know, I honestly understand it's it depends on everyone's facts and circumstances, but just good to think about.
• 35:15
  SPEAKER_04: Well, this has been a great discussion and a great reminder that debt classification is not always as easy as you think and that there's more judgment involved.
• 35:23
  SPEAKER_04: So I think one more reminder for our listeners as well if you're looking for more detail, you can check out chapter 12 of PWC's financial statement presentation guide, which covers debt classification and many of the examples that we discussed today in more detail.
• 35:39
  SPEAKER_04: So thank you again, Chris and Suzanne, for joining me today.
• 35:42
  SPEAKER_04: Yeah, thanks.
• 35:44
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• 36:06
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