The Financial Accounting Standards Board has given preliminary approval for adoption of new rules regarding the classification of debt, and these new rules could have a significant impact on a contractor’s balance sheet and state capacity ratings.
Current Rules of Debt Classification
Under the current rules, debt may be classified as long-term on the balance sheet if it: (a) has a stated maturity date of more than 12 months after the balance sheet date; or (b) is renewed or refinanced after the balance sheet date, but before the issuance of the current year’s financial statements, for a period that extends more than 12 months after the balance sheet date.
Proposed New Rules
Under the proposed new rules, debt would be classified based on its status as of year-end, without regard to any extensions or refinancing after year-end.
A company with a December 31st year-end has a line of credit that is due for annual renewal in two months, on February 28th. Under current rules, borrowings on the line of credit at December 31st could be treated as long-term if the line of credit was renewed in the following year before the current year financial statements were available to be issued. Under the proposed new rules, these borrowings would be treated as a current liability, as renewals and refinancing after year-end would not be considered in determining current versus long-term treatment at the balance sheet date.
Additional Provision for Covenant Violations
Consistent with current practice, covenant violations would not require current liability classification for long-term debt obligations if waivers are obtained subsequent to year-end. However, debt for which covenant waivers are obtained will be required to be reported separately in the company’s balance sheet.
Impact of Proposed Rules
The proposed rules could adversely impact working capital, which is a key factor in credit decisions by financial institutions and bonding companies. However, the adverse impact to working capital could also reduce your capacity ratings for state prequalification purposes.
If adopted as presently proposed, the new rules would be effective for fiscal years beginning after December 15, 2021. We recommend that you take proactive steps before that date to make certain the maturity dates of your long-term debt obligations are extended at least one full year beyond your year-end. In some states, to maximize your capacity ratings, maturity dates should be extended at least two full years beyond your year-end.
If you would like to discuss specific considerations for your company, how to strengthen your company’s balance sheet and improve your company’s working capital and/or your state capacity rating, please contact us.