FASB Project Simplifying the Balance Sheet on Classification of Debt

FASBProject: Simplifying the Balance Sheet on Classification of Debt

Abstract

TheFinancial Accounting Standards Board is mandated to establish andreview accounting standards and procedure with the objective ofclarifying the gray areas, remove unnecessary complications, andsimplify the process of preparing financial statements. The balancesheet simplification on classification of debts is an ongoing projectthat will reduce the gaps that are abused by fraudulent accounts andremove unnecessary complexities involved in the process of classifieddebts as either non-current or current obligations. Currently, FASBhas agreed on several aspects that include the use of theprinciple-oriented method instead of a rule-oriented method of debtclassification, treatment of debts that are waived by lenders afterthe violation of covenants, treatment of debts that are subject toacceleration by their lenders using subjective clauses, and thedisclosure of all debts that are waived following the violation ofthe terms agreed upon by the entity and the lender. The project willincrease the proportion of current assets, which will affect theperceived liquidity of organizations in a negative way.

Keywords: Simplification of balance sheet, FASB short-term projects,non-current liabilities, debt classification, current obligation.

FASBProject: Simplifying the Balance Sheet on Classification of Debt

Standardsthat guide accountants in preparing financial records are developedand approved by the Financial Accounting Standards Board (FASB). Theprimary mandate of the FASB is to establish the financial reportingstandards and review them frequently in order to enhance disputedsections and remove unclear sections (Deloitte Global Service, 2015).Inaddition, the fact that the accounting standards are established andreviewed by one body ensures that the financial reports preparedusing those standards follow similar procedures and they can beunderstood different users. Most of the current FASB projects seek toshift the accounting standards from the rule-based to theprinciple-oriented method, which will enhance the quality of thefinancial reports (Agoglia, Doupnik &amp Tsakumis, 2011). Theprocess of establishing and reviewing accounting standards isnormally undertaken in the form of short-term projects that seek toachieve different objectives. This paper will analyze one of theseshort-term projects, which involves the simplification of the balancesheet with a focus on the classification of debts.

Background

Thesimplification of the balance sheet is among the short-term projectsthat are undertaken by the FASB. The objective of the project was toenhance accounting standards and create a narrow-scope simplificationfor classification of the balance sheet items, including debt (DGS,2015). Although the initiative to simplify the balance sheet focusedon several balance sheet items, FASB emphasized on the simplificationof the classification of debt. FASB announced the objectives of theproject at its meeting held on July 29, 2015. The objective was todevelop an overarching and a more comprehensive method of debt, whichwould replace the current fact-pattern approach (DGS, 2015). As thename of the project suggests, the purpose of FASB was to simplify theclassification of debt by reducing the complexity and the unclearareas that hinder the process of determining whether debt should beclassified as non-current or a current item in the balance sheet.

Scopeof the project

Theproject undertaken to refine the rules for the classification of debtwould only focus on debt arrangements offer lenders with contractualrights to get money and give borrowers a contractual obligation tomake payment for a specified amount of money on a fixed, determineddate, or on demand (DGS, 2015). This means that the project’s mainfocus would include two items or types of debt. The first type ofdebt would be a convertible debt, even if this kind of debt could besettled in terms of shares. The second type of debt would includefinancial instruments that are redeemable and are classified underASC 480-10 as liabilities, even if such types of instruments appearin the form of equity shares.

Acase that triggered FASB’s project

Therule-based approach has been quite lenient and unambiguous, which hasincreased the chances for misclassification of debts as eithernon-current or current liabilities. Centro case, 2011, is one of theactual events that might have provoked FASB to initiate a projectthat will see the field of accounting shift from the rule-oriented toa principle-oriented approach when classifying debts as eithernon-current or current. In the Centro case, the accountant classifiedpart of the borrowing or a loan as non-current, which yielded a boneof contention on whether the borrowing could be classified as such(Cullen, 2015). The entity held that it had given a guarantee as partof the borrowing transaction while the Security and InvestmentCommission stated that the transaction was a material post-reportingdate event that ought to have been disclosed. The directors of theentity, Centro, defended themselves by stating in Cullen (2015) that,“there had just been a change in the relevant accounting standardand some grayness in its interpretation” (p. 1). The gray areas inthe rule-oriented approach on the issue of classification of debtsmight have motivated FASB to initiate a project that would result inthe development of clear provisions for classification of debts in asimplified way when preparing the balance sheet.

Currentguidelines for classification of debt

Accountantsfollow the requirements set out in the International AccountingStandards 1 (IAS 1) to classify liabilities (including debt) aseither non-current or current. Under section 69 of ISA1, accountantsare required to classify debt and other liabilities as current ifthey meet four conditions. First, the organization should expect tosettle the debt within its normal operating cycle (Flao, 2013). Inother words, the company should expect to settle the debt within asingle financial period. Secondly, the debt should have been held forthe sole purpose of tradition. Third, the company expects to settlethe debt within a period not exceeding 12 months after the date ofreporting it in the balance sheet. Lastly, the company shouldclassify the debt as current when it does not have some unconditionalright to defer the settlement of that debt for a period of at least12 months following the reporting date (DGS, 2015). All debts that donot meet the four conditions are classified as non-current.

Section72 of ISA 1, extends section 69 by stating that debts and otherliabilities should be classified as current as long as theirsettlement will be met within a period that does not exceed 12months, even if the term that was originally agreed is more than 12months (Flao, 2013). This classification should also be made even ifthe agreement made to refinance the debt or reschedule its paymenthas been completed after a given reporting period and before theissue of the debt has been authorized. Section 73 of ISA 1 allowsaccountants to classify debt and other liabilities as non-currentwhen the company expects and has full discretion, to roll over orrefinance the debt for a period of at least 12 months following thereporting period and under some existing loan facility. Thisclassification is done even if the debt would become due within aperiod that is shorter than 12 months (DGS, 2015). Otherwise, thecompany classifies the debt as current when it does not have thediscretion to roll over or refinance it.

Currentstatus of the project and tentative decisions

Newprinciples for classification of debt

FASBresolved to adopt the principle-based method of classifying debtinstead of the current set of guidelines that is difficult tonavigate and complex, in spite of the fact that it addresses narrowissues. Under the new principle-based approach, the board agreed thata debt should be classified as a non-current item in the balancesheet if it meets a set of conditions. First, the debt should becontractually due for settlement in a period of not less than 12months after a given balance sheet date (DGS, 2015). Secondly, theentity or the company should have some contractual right to defer thesettlement of the liability within a period of at least 12 monthsafter a given balance sheet date.

Unlikethe previous requirements where liabilities were classified usingprovisions of a set of guidelines, the FASB decided that allliabilities, especially the debt, should be classified on the basisof specific facts and circumstances that prevail at a given balancesheet date (DGS, 2015). This implies that, once the balance sheetsimplification project is finalized and its provisions approved,entities will only be allowed to consider their contractual rights ata specific balance sheet date. In addition, FASB recommendationssought to reduce the complexities that results from the use of theU.S. GAAP. For example, the U.S. GAAP requires entities to takeaccount of all events that occur after a given balance sheet datewhen classifying debt. One of the key events that may be consideredunder the current U.S. GAAP is an issue of equity securities or along-term debt that is intended to refinance some short-termobligations, even if such an event takes place after a given balancesheet date (DGS, 2015). Entities will no longer be required toconsider events or rights that are received after a given balancesheet date, but prior to the issuance of the financial statementsonce the FASB recommendations are approved.

Violationof debt covenant and its waiver

Entitiesnormally apply for waivers whenever they violate the debt covenants,but such waivers are, in most cases, awarded after a given balancesheet date. Under the current accounting rules or the GAAP, entitiesare allowed to classify some post balance sheet date transactions(such as plans to refinance the short-term liabilities) on thelong-term basis (Butt, 2015). After the approval and the subsequentapplication of the FASB’s recommendations, the debts which waiveris not accepted at the end of a given balance sheet date iscategorized as a current debt. The board foresaw a timing challengeand addressed it by issuing an exception in order to avoid anypossible complications that would arise from its recommendations. TheFASB held that accountants could only consider waivers that arereceived after a given balance sheet date, but before the entity’sfinancial statements are issued (DGS, 2015). Most importantly, FASBretained the current guidance that emphasized on the need to evaluatethe entity’s ability to comply with convents in the future. Thismeans that borrowers or the entities will still be allowed toclassify waived liabilities in case the lender agrees to waive theright to demand for payment for a period of 12 months after a givenbalance sheet date (DGS, 2015). Therefore, the most significantchange that will be achieved by the FASB project is a clarificationof timing of waivers on debt covenants that have been violated.However, debts that will be classified as non-current as a result ofthe aforementioned exemption will presented separately.

Clauseson subjective acceleration

Theclassification recommended by FASB will eliminate the probabilityevaluation of subjective acceleration clauses (SACs) as required bythe current GAAP. The FASB held that clauses that allow the lendingentities to accelerate the maturity of some debt under conditionsthat are subjectively determined will only impact classification ofdebt when they are triggered (DGS, 2015). Debts that become payableon demand or callable can be classified as current, as long as thesubjective clauses are triggered. However, long-term debts will stillbe classified as non-current liabilities even in circumstances underwhich they are subject to SACs. This is inconsistent with the currentGAAP that require such long-term liabilities to be classified ascurrent due to liquidity and recurring losses.

Disclosureand transition

FASBupheld the disclosure requirements under SEC Rule 4-08, which requireentities, both private and public, to disclose debts that areaffected by provisions for covenant violations. Under the newprinciple, entities will be required to disclose both the existenceand the nature of debt covenants and significant SACs.

Implicationsof the project

Theprinciple-based approach of classifying debts will have majorimplications. First, debts that were previously classified asnon-current will now be classified as current. For example, the newFASB proposal holds that debts are only classified as non-currentwhen they are considered to be due for contractual settlement for aperiod that exceeds 12 months after a given reporting date, and otherdebts are classified as current (DGS, 2015). In addition, theproposal requires entities to classify debts that can be acceleratedusing subjective clauses as current debts. This will impact theliquidity of entities in a negative way since the proportion ofshort-term liabilities as presented in the balance sheet willincrease. This might influence users of the financial statements(including suppliers, shareholders, and customers) to conclude thatthe entity has liquidity difficulties.

Secondly,the FASB’s proposal will ease the process of preparing the balancesheet since accountants will be guided by clear principles as opposedto a set of rules that vary from one jurisdiction to another. Inaddition, the principle-based approach will ensure that debts areclassified in a standard way since requirements of FASB’s, unlikethe current rule-oriented approach, will lead to consistent results(DGS, 2015).

Conclusion

Thereview and amendment of the accounting and financial reportingstandards is an ongoing process that seeks to remove the bottlenecksas well as the gray areas that are discovered from time to time. Thebalance sheet simplification project that is being undertaken by theFASB is among the key initiatives that seek to reduce complexity aswell as the cost of classifying debts during the process of preparingthe balance sheet. Some of the aspects that FASB members have agreedupon include the shift from the rule-oriented to the principleoriented method of classifying debts, treatment of debts that involvea waiver for violation of covenants, classification of debts that aresubject to acceleration by lenders using subjective clauses,provisions for disclosure of debts that are affected by waiver forthe violation of the covenants. Although these agreements will reduceunnecessary jargons that are currently involved in the preparation ofthe balance sheet, it will increase the proportion of currentliabilities, which will in turn affect the stakeholders’ perceptionabout the liquidity of the affected entities.

Annotatedbibliography

Agoglia,P., Doupnik, S. &amp Tsakumis, T. (2011). Principles-based versusrule-based accounting standards: The influence of standard precisionand audit committee strength on financial reporting decisions. TheAccounting Review,86 (3), 747-767.

Thearticle compares the differences between the rule-oriented and theprinciple-oriented standards of accounting. Most importantly, theauthors hold that the principle-oriented standards are primarilydesigned to address the weaknesses of the rule-based standards ofaccounting. For example, the rule-based standards have many flawsthat are exploited scrupulous accountants to misrepresent figures inthe financial statements, which reduces the quality as well as thereliability of the financial statements are prepared using therule-oriented standards. The article is a useful source that informedthe current study on how the FASB’s decision to applyprinciples-based standards in classifying debts will reduceunnecessary complications and reduce chances for abuse of financialstatements.

Butt,R. (2015). Debt covenant violation and cost of borrowing: Evidencefrom quarterly bond issues. InternationalResearch Journal of Applied Finance,6 (2), 75-108.

Buttexplains how the event of violation of the debt covenant should betreated under the current accounting standards. Entities are free torequest and negotiate with lenders for waivers related to covenantsthat they might have violated. However, debts that exist at a givenbalance sheet date and for which the waiver has been issued extendingthe terms for a period of more than 12 months are recognized asnon-current assets. However, the author holds that any cases ofviolations should be reported to the relevant bodies, including theSecurities and Exchange Commission. The article is useful because itinformed much about the treatment of the violation of debt covenantsunder the current accounting standards, which provided the basis ofcomparison with the provisions of FASB project on classification ofdebts.

DeloitteGlobal Service (2015). Journal entry – FASB decides to issue proposedASU on simplifying the balance sheet classification of debt. DeloitteGlobal Service.Retrieved November 6, 2015, fromhttp://www.iasplus.com/en-us/publications/us/aje/2015/0730

Thearticle offers a discussion of achievements that FASB has made withregard to its short-term project that seeks to simplify the balancesheet, especially the classification of debt. The article states thekey factors that motivated FASB to initiate the project, whichinclude the need to reduce complexities involved in the process ofclassifying debts. In addition, the article provides the scope of theproject by indicating that FASB has only been focusing onclassification of convertible debts and financial instruments thatare mandatory redeemable. Most importantly, Deloitte highlighted allissues that FASB member have already agreed, and which awaits theireffective dates. The article is useful for the present study becauseit provides information about the current status of the short-termproject for simplification of the balance sheet and classification ofdebts.

Cullen,K. (2015). What does the Centro case mean for directors? LaytonUTZ.Retrieved November 6, 2015, from&lthttp://www.claytonutz.com/publications/news/201106/29/what_does_the_centro_case_mean_for_directors.page&gt

Cullenprovides the analysis of the case that was tagged as “Centro”,which involved the misclassification of borrowings. The directors ofCentro were sued for approving financial statements that containedborrowings that were classified as current, instead of non-currentassets. The main argument made against the defendants was that thedirectors ought to have discovered that the borrowings weremisclassified by the company’s accountant. It was also held thatthe guaranteed issued by the company after the financial reportingdate in relation to misclassified debt was material and should havebeen disclosed appropriately. This is an important case thathighlights the impact of the gray area in the rule-orientedaccounting standards, which could be one of the factors thatmotivated FASB to initiate the project for simplification of theprocess of classifying debts.

Flao,P. (2013). Annualimprovements to IFRSs 2010-2012 cycle-comments.London: IFRS Interpretations Committee.

Flaodiscusses how financial reporting standards are enhanced with timewith the main focus on the improvements that were made in thefinancial year 2010-2011.However, these reforms were rule0-basedsince the FASB project on simplification of the balance sheet had notbeen completed. The author highlights the key rules that have beenused by accountants to classify debts and other types of liability aseither non-current or current. For example, Flao states that entitiescan classify debts as current when they expect to settle them withinthe single financial period or within 12 months, but that liabilitymust only be meant for trade only. The article provides usefulinformation about classification of debts under the current rulesthat are quite general and contains unspecified provisions, whichjustifies the FASB’s decision to go for principle-orientedstandards.

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References

Agoglia,P., Doupnik, S. &amp Tsakumis, T. (2011). Principles-based versusrule-based accounting standards: The influence of standard precisionand audit committee strength on financial reporting decisions. TheAccounting Review,86 (3), 747-767.

Butt,R. (2015). Debt covenant violation and cost of borrowing: Evidencefrom quarterly bond issues. InternationalResearch Journal of Applied Finance,6 (2), 75-108.

Cullen,K. (2015). What does the Centro case mean for directors? LaytonUTZ.Retrieved November 6, 2015, fromhttp://www.claytonutz.com/publications/news/201106/29/what_does_the_centro_case_mean_for_directors.page

DeloitteGlobal Service (2015). Journal entry — FASB decides to issueproposed ASU on simplifying the balance sheet classification of debt.DeloitteGlobal Service.Retrieved November 6, 2015, fromhttp://www.iasplus.com/en-us/publications/us/aje/2015/0730

Flao,P. (2013). Annualimprovements to IFRSs 2010-2012 cycle-comments.London: IFRSInterpretations Committee.