The coronavirus (COVID-19) is an ongoing, pandemic disease which the World Health Organization (WHO) first declared as an outbreak that was a Public Health Emergency of International Concern on January 30, 2020 and then classified as a pandemic in March 2020. As the health and human toll continue to develop, the economic destruction is already significant and represents the biggest disruption the world has experienced in decades. In a dubious economic environment, many entities are impacted by cash flow challenges or foresee future potential challenges. As a result, these challenges have negatively impacted debt service and/or have resulted in additional funding requests, renegotiation of existing debt terms, negative operational impacts resulting in debt covenant failures that have necessitated waivers from lenders or, in worse scenarios, defaults. Any change in existing debt arrangements could impact the classification and accounting for these arrangements, depending on the nature and significance of the amendment.
Why is it important?
Occurrence of any debt covenant violations may require evaluation of whether these are a recognized or non-recognized subsequent events under Accounting Standards Codification (ASC) Topic 855, Subsequent Events. Furthermore, whenever entities amend the terms of their existing debt arrangements to address covenant violations, modify debt service commitments, extend maturity dates, obtain additional financing, etc.; such amendments should be evaluated under ASC Topic 470, Debt, to determine the appropriate accounting treatment. Amendments can fall under the following categories: (a) debt modification; (b) debt extinguishment; or (c) a troubled debt restructuring.
Covenant violations and related balance sheet classification:
Whenever a debt covenant breach occurs, entities should evaluate the balance sheet classification at the reporting date depending on when they occur and whether or not a waiver, extension or some other form of a cure, is obtained and when.
As a general rule, a covenant violation and default that occurs on or before the reporting date such that the debt becomes puttable on demand is presented in the balance sheet as short term debt, while a covenant violation occurring after the reporting date is considered a non-recognized subsequent event under ASC Topic 855, which does not impact the balance sheet classification of debt at the reporting date. Entities should evaluate not only when the covenant violation occurred (i.e. on or before the reporting date or after the reporting date) but also when the cure occurred (i.e. on or before the reporting date, after the reporting date or after the reporting date but prior to the issuance of the financial statements). A combination of these various scenarios could result into a different balance sheet presentation.
Debt modifications during the COVID-19 crisis
The CARES Act provides optional relief from accounting for certain short-term modifications due to COVID-19 related events as troubled debt restructurings (TDR). The CARES Act provides financial institution lenders with the option to suspend the accounting requirements for loan modifications related to COVID-19 related events that would otherwise be TDRs. For a loan to be eligible, the loan modification must be:
- related to COVID-19 related events,
- modified between March 1, 2020 and the earlier of
- 60 days after the national emergency related to COVID-19 ends, or
- December 31, 2020, and
- executed on a loan that was not more than 30 days past due as of December 31, 2019.
Considerations have been made about whether borrowers can likewise use the above guidance to determine that a modification is not a TDR following the requirements of ASC Topic 470, Debt. Consequently, FASB has confirmed that borrowers that modify existing debt arrangements under a modification or deferral program mandated by the federal or a state government due to COVID-19 may conclude that the modification is not a TDR under ASC Topic 470. Care should be taken to ensure that the modification is as a result of a government mandate, otherwise, a borrower is not allowed to apply the guidance above by analogy and conclude that the modification is not a TDR. Consequently, the borrower should apply the pre-COVID-19 accounting rules (see flowchart above) to determine whether the modification is a TDR.
The COVID-19 pandemic has created a worldwide financial crisis that necessitates many entities amend the terms of their existing debt arrangements to be able to maintain certain levels of liquidity and operational requirements. Entities are therefore required to assess the appropriate accounting treatment for these amendments and whether or not these qualify as troubled debt restructurings. If not, entities will need to perform further assessments to determine if there is a debt extinguishment or modification. Each of these assessments could result in significantly different accounting treatments.
Other than impacting the debt classification in the balance sheet, debt covenant failures may also need to be evaluated on a broader scale when determining an entity’s ability to continue as a going concern, one year after the financial statements are issued.
Entities should be proactive in taking actions to address the potential accounting effects of debt modifications to their existing debt arrangements. This may include review of covenant calculations sooner and assessing whether a violation has transpired or is likely to transpire at the reporting date. This will assist the entity in determining if there is a need to secure a waiver or grace period from the lender and determine if they have the ability to meet the covenants in the future or otherwise consider renegotiations of covenant clauses with the lenders.