FASB Moves Ahead with Debt Simplification Project

Simplifying and reinforcing the conceptual reporting framework will remain top priorities of the Financial Accounting Standards Board (FASB) in 2015. The classification of debt is one of its current targets. At its January meeting, FASB reiterated plans to eliminate the current rules and develop an overall principle for debt classification that’s aligned with International Financial Reporting Standards (IFRS).

Simple but transparent  

In a recent speech at the American Institute of Certified Public Accountants (AICPA) conference, FASB chairman Russell Golden identified “clutter within our accounting standards” and the lack of a conceptual framework as reasons for inconsistent, complex financial reporting. He mentioned the classification of debt as one of 70 specific areas where companies and auditors feel there’s unnecessary complexity and there are costs that could be reduced by promoting simplification — without impacting the transparency to investors. 

FASB included the debt project in its August 2014 simplification initiative, which focused on narrow, complex parts of U.S. Generally Accepted Accounting Principles (GAAP) and attempts to make relatively quick amendments. The board homed in on the presentation of debt on the balance sheet because the existing standard requires companies and auditors to consider specific rules that depend on the type of debt arrangement, such as a loan covenant, revolving credit and lock box arrangements, increasing-rate debt and callable debt. The current standard doesn’t include all scenarios, however.

The board wants the amended standard to include an overarching principle that will classify debt on the basis of a contract’s terms and the company’s compliance with the loan or bond covenants. A memo prepared for FASB’s January meeting states, “The introduction of a single principle, in place of rules-based guidance, is expected to reduce cost and complexity for preparers and auditors while improving the usefulness of the information reported to financial statement users.”

Current vs. long-term debt

Companies familiar with the prescriptive, rules-based guidance for classifying debt on their balance sheets may soon need to adapt to a looser principle that works for all debt arrangements. The change is important to companies that want to clearly distinguish between the debts that must be paid in the near term and the debts for which they have more time to pay. 

When evaluating the liabilities section of the balance sheet, investors essentially want to know whether it looks like a company can meet its obligations over the next few months and how a company plans to manage its resources. Because long-term debt will be funded by future operations, investors see it as less burdensome than current obligations.

Under GAAP, companies must assess the details of their liabilities to distinguish between current and long-term debt. The AICPA defines current liabilities as “obligations whose liquidation is reasonably expected to require use of existing resources properly classified as current assets, or the creation of other current liabilities.” FASB considers debts as current if they mature within one year or the operating cycle, whichever is longer. 

Accounts payable and current maturities of long-term debt are obvious examples of current liabilities. But the waters get muddier when dealing with debts that may be refinanced, hybrid contracts with elements of both debt and equity, contingent obligations and debts that will be settled with long-term assets.

Under FASB’s current proposal, a company’s debt would be labeled as noncurrent if it’s due to be settled more than a year after the reporting period, or if the business has the right to defer settlement for at least a year. This simple principles-based guideline takes its cue from International Accounting Standards 1, Presentation of Financial Statements. The proposed amendment would clarify that debt arrangements give a lender the right to receive money and require a borrower to make payments. It also would include guidance on what it means to have the right to defer settlement and examples of debt arrangements, making it clear that the list wasn’t comprehensive.

In addition, the proposed amendment would require companies to consider their legal rights in their debt contracts and make a determination based solely on those rights. The business wouldn’t consider whether it expects its lender to exercise its rights, such as calling for the debt to be settled earlier than expected.

Fewer rules, more judgment

As GAAP continues to replace prescriptive, rules-based standards with looser, principles-based standards, companies will need to adjust to a new mindset. Fortunately, your accounting advisor can help interpret how the proposed guidance on debt and other simplification projects may affect your company’s financial statements. 

© 2015