Hello. In this lesson,

we're going to talk about some exceptional situations.

These are situations where something that you might expect would be a current liability,

maybe isn't, or maybe something that you wouldn't

expect to be a current liability maybe is.

Let's take a look at some of these.

So when might a short-term obligation actually be classified as long-term?

A short-term obligation, when could it be classified as long-term?

Remember, companies sometimes borrow money on

a 60 or 90-day cycle or maybe in little bit longer,

and the cases, do they do this all the time?

Is it just that there is an expectation that there are always going to recycle those?

Well, once upon a time,

companies would have classified those as long-term,

except that caused some problems.

There was a dramatic bankruptcy of a company known as

Penn Central that caused the FASB to look at this and go,

"No, that's not good enough."

It has to be refinanced on a long-term basis.

So, what if I have a year loan? A one year loan?

And I do expect to refinance it for another year.

And, therefore, it won't be expected

to require the use of working capital during that year.

And this is very common with commercial paper, with construction loans,

where this is essentially a short-term loan that

you're only going to have during the construction period.

At the end of the construction period,

whoever purchases the building is usually going to get permanent financing for it.

So a construction loan is sometimes known as interim financing or a bridge loan.

And, also, you can have currently maturing portions of long-term debt.

So if I have a six or seven-year loan,

and this happens to be that year when that loan comes due,

that whole amount could be classified as a current liability,

as we talked about in the previous lesson.

Well, if I intend to refinance that,

and I have the ability to do that,

is it really a current liability?

The FASB did put some conditions on when I can take what would

otherwise be a current liability and classify it as long-term.

It's a matter of ability and intent.

You have to be able to demonstrate

that you have the ability to consummate the refinancing.

You have sufficient credit standing.

You have the consent of a lender.

So, if you do have that ability and intent,

and before the balance sheet data is issued or is available to be issued,

you can't hold it back when it's available in order to complete a financing.

But if it's either issued or available to be issued,

and you have entered into a financing agreement to

refinance that short-term obligation on a long-term basis,

you might be able to classify it as long-term.

And that would be the case if the agreement is long-term.

It does not expire within one year.

And there's no violation of any provision exist that the balance sheet date,

you'd haven't violated any loan covenants.

Loan covenants are provisions in

a debt agreement that the lender puts in there to ensure that,

well, to provide reassurance that they're going to get

their money back, preferably with interest.

So these loan covenants often make use of gap figures.

So they're very important part of financial reporting.

So if there's no violation of any of these provisions and

the lender themselves is financially capable of making the loan,

you can't have a brother-in-law, for example,

that may not have the money vouching to make the loan to,

but if you have a lender that's financially capable,

there's no violation, and they agreed to

something that won't expire within one year, well,

then you can classify what would otherwise be

a short-term current liability as long-term.

By the way, this is not the case with International Financial Reporting Standards.

They require that the financing arrangement be in place before the balance sheet date.

So this is an exception,

a difference between United States gap in International Financial Reporting Standards.

What about the other way?

When might you have a long-term debt that may appear to be due in four,

five, six years, 20 years but that actually might be a current liability?

Well, one example of that situation could be debt that's callable any time.

What do we mean by callable?

We mean that the lender can just demand payment at any time. Yeah, yeah.

It's a six year-loan,

but I want my money now.

Let me have it. Well, if the loan's callable at any time,

it might have language in there.

The note can mature in monthly installments there or on demand,

or principal and interest will be due on

demand or if no demand is made, in quarterly installments.

So you need to look closely to make sure there isn't

language like this in a loan because it would

take what might otherwise be long-term

that enclose it to be classified as a current liability.

What if the debt is not callable on demand,

but it can be called on violation of

one of these debt covenants that I was talking about a few minutes ago?

If there is a provision of the debt agreement that makes the obligation callable,

what could that be?

Well, sometimes the debt is

callable if you take on additional debt without the permission of the vendor,

or if your sales declined by more than 10 percent,

or if your cash position declines to a certain position.

There can be a number of conditions where the lender may

have decided that the loan has become more

risky due to one of the provisions that they've put in the loan to protect themselves,

and they can call when you're in violation of that provision.

So, and lot of times,

it will say, "Okay,

if you have a violation,

there's a grace period that you can cure the violation.

Otherwise, it will be callable."

So you're going to look and see what exactly the agreement says.

So you're going to classify though,

this loan is a current liability unless

the creditor has waived or somehow lost

the right to demand repayment for more than one year.

Again, so it's no longer a current liability,

it has to go beyond that one-year frame or the operating cycle if longer.

Or if the obligation contains a grace period to cure the violation,

yes, you've done something wrong.

You've violated this provision,

but if you cure it within 60 days,

if you correct it within 60 or 90 days, then we're okay.

We won't call the loan.

So, now, we're going to look and see whether it's probable

that violation will be cured during that period.

Why we have this provision?

Sometimes companies don't know they're in

violation until they see their financial statements,

to tell the truth, especially if the clauses are based upon their financial statements.

But if they haven't obtained

a waiver and it's not probable

that they'll be able to cure it within a grace period or there is no grace period,

it's a current liability.

It looks like a long-term liability,

but you would classify it as a current liability.

This is one of my favorites.

This is one that has tripped up people in many, many situations.

Sometimes those provisions,

those debt covenants are written in a manner that they are subjective.

So instead of saying,

we can call the loan if net income declines by 10 percent,

or if sales declined by five percent,

or if debt, other current liabilities exceed current assets by $1 million,

these are all objective figures that

two reasonable parties can look at and arrive at the same conclusion every time.

They are objective conditions.

What if it's subjective?

What if it's worded in such a fashion that you're

not exactly sure when you may or may not be in violation?

So that would be in agreement that you could accelerate scheduled maturities

called the debt under conditions that are not objectively determinable.

For example, it might say something like,

"We can call the debt if the borrower fails to maintain satisfactory obligations."

Or what does satisfactory mean? That's subjective.

Or, and this is very common language,

if there's a material adverse change in the business or a material adverse event,

again, it's a matter of opinion as to what that is.

You can't be sloppy,

for lack of a better word,

and put vague language in a loan and still have it classified as long-term debt.

A subjective acceleration clause is going to cause

the debt to be considered callable on demand and,

therefore, a current liability.

So did you notice a pattern here?

The principle is that any debt that could become

payable at the discretion of the lender is going to be a current liability.

And that would be the case of callable on demand,

or if you've violated a provision,

and it's now callable on that basis,

or if there's a subjective criteria for when the lender can call it.

All of those would mean that the lender really controls the timing of repayment.

You're at their mercy.

So the obligation may be a current liability even if

the lender doesn't intend to enforce that right.

So we've talked about some exceptions to

the normal classification of a current liability.

What that means when you're working in the field,

when you're auditing, or preparing the books for a company that has debt,

you need to look at the agreement closely and make sure that a short-term debt

may actually qualify as long-term debt if it's been classified that way,

but also, look at the long-term debt and make sure there aren't any provisions within

that debt that would cause it to be classified as a short-term or current liability.

Exceptional Situations

Accounting Analysis II: Measurement and Disclosure of Liabilities

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