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How to Classify Debt With Covenants?

How to Classify Debt With Covenants

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How to Classify Debt With Covenants

Debt with covenants refers to loans or other forms of borrowed money that come with conditions set by the lender, known as covenants. These conditions may relate to maintaining certain financial ratios, limitations on further borrowing, or restrictions on payments of dividends, among others.

The classification of debt with covenants depends on the specific conditions set by those covenants. Here are two primary scenarios:

  • Current Liability: If a borrower violates a covenant condition, and this violation gives the lender the right to demand repayment immediately or within one year, the debt is classified as a current liability. This is because it could become due within the next year, even if the loan’s original term is longer.
  • Non-Current Liability: If the borrower is in compliance with all covenant conditions and is expected to continue to be in compliance for at least one year, the debt can be classified as a non-current liability (assuming the repayment date is more than a year away).

In the event of covenant violation, a debt classified as non-current might need to be reclassified as current. This reclassification would occur in the period when the covenant was violated, not in the period when the loan might potentially be called due.

Also, regardless of the classification, a company is generally required to disclose information about their debt covenants in the notes to the financial statements. This can include the nature of the covenants, the limits set by the covenants, and whether the company is in compliance with the covenants.

Keep in mind that classification can vary based on different accounting standards and the specifics of the covenant. When dealing with complex financial situations such as this, it’s best to consult with a professional accountant.

Example of How to Classify Debt With Covenants

Company ABC has a long-term loan from Bank B for $1,000,000 that matures in 5 years. The loan agreement includes a financial covenant requiring that Company ABC must maintain a current ratio (current assets divided by current liabilities) of at least 1.5. This means the company must have 1.5 times as many current assets as current liabilities.

As per the last audited financial statements, the current ratio of Company ABC is 1.7, which is in compliance with the covenant.

Here’s how it should be classified:

  • Because the company is in compliance with the covenant, and assuming it expects to continue to comply for at least the next 12 months, the debt would be classified as a long-term liability, as the debt repayment date is more than a year away.

The balance sheet might show:

Non-Current Liabilities:

  • Long-term debt (Loan from Bank B): $1,000,000
  • Other non-current liabilities: $200,000
  • Total non-current liabilities: $1,200,000

However, suppose in the next quarter, due to some operational issues, the company’s current liabilities increase significantly, and its current ratio drops to 1.3, thus violating the covenant. In this case, the bank would have the right to demand repayment of the loan.

Here’s how it should be reclassified:

  • This debt would now need to be reclassified as a current liability because the covenant has been violated and the bank could demand repayment within the next 12 months.

So, the balance sheet might be adjusted to show:

Current Liabilities:

In both cases, the notes to the financial statements should disclose the covenant and the fact that the company was in compliance or violation as of the balance sheet date.

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