Classification of long-term debt as a current liability in an entity’s balance sheet: significance of debt agreement provisions
Updated : November 13, 2019
Some questions exist in practice on whether or not to classify long-term debt as a current liability when an entity applies accounting standards for private enterprises (ASPE) in Part II of the CPA Canada Handbook – Accounting. Current classification of debt is especially common for callable long-term debt (even though such debt is repayable over many years), as well as for long-term debt that is renegotiable in the following year.
Note that paragraph .13 of CURRENT ASSETS AND CURRENT LIABILITIES, Section 1510, clearly indicates that non-current or current classification of debt is based on facts existing at the balance sheet date rather than on expectations regarding future refinancing or renegotiation. In other words, if the creditor has the right to demand repayment of a debt at the balance sheet date or within one year from that date, the obligation should be recognized in the entity’s balance sheet as a current liability, even though the creditor clearly has no intention of demanding repayment in the short term, or will renew the loan in the following year.
The classification of long-term debt as a current liability is therefore very common in the following situations:
1. The long-term debt is callable: credit facilities of financial institutions very often include a contractual provision giving the financial institution the right to demand repayment of long-term loans1. In other words, the financial institution reserves the right to demand repayment of loans at any time, even though the repayments are scheduled over many years. While this is common practice among financial institutions, practitioners are often unaware of it, since bank confirmations do not necessarily include this information. Loans with no stated repayment terms ("without repayment terms"), notably between related parties, are deemed to be payable on demand and must also be classified as current. It is the same for retractable shares issued.
2. The long-term debt is renewable within one year of the balance sheet date: as part of the long-term debt renewal (for example, a mortgage amortized over 20 years, renewable after five years), the financial institution generally has the right to cancel the credit facility at the end of the term (of five-year in the example) and demand repayment of the loan, even if it is almost certain that the loan will be renewed.
3. The long-term debt has a covenant violation at the balance sheet date: sometimes long-term debt can have a covenant violation at the balance sheet date, which gives the creditor the right to demand repayment of the long-term debt.
In the three situations described above, the entire long-term debt should be classified as a current liability in the balance sheet2.
However, in any of these situations, the entity will not be required to reclassify long-term debt as a current liability if, between the balance sheet date and the date of completion of the financial statements, the creditor has waived in writing the right to demand repayment of the debt for a period of more than one year or if the obligation has been refinanced on a long-term basis. Although, regarding the third situation, if the creditor has only waived the right to demand repayment arising from violation of the covenant at the balance sheet date, pursuant to paragraph .14 of Section 1510 a second condition must be met in order not to reclassify a long-term debt as a current liability. It must be unlikely that a violation of the debt covenant giving the creditor the right to demand repayment at a future compliance date happens within one year of the balance sheet date3.
Practitioners should therefore be vigilant when determining where to classify debt in an entity’s balance sheet, since many obligations have characteristics that require the entire amount to be classified as a current liability. Pursuant to the Professionnal Inspection Review Annual Report 2018-2019, the misclassification of those three types of financial liabilities continues to be one of the most common weaknesses.
Paul Beauvais, CPA auditor, CA
Member of the Technical working group on ASPE – Financial Accounting – Part II
Original version published : November 12, 2013
Professional Practice, Assurance and Financial Accounting
ORDRE DES COMPTABLES PROFESSIONNELS AGRÉÉS DU QUÉBEC
Updated : November 13, 2019
1 Instead of including provisions to that effect in the debt agreement itself, some loans with a long-term repayment schedule are sometimes accompanied by a promissory note, payable on demand, appended to or separate from the contract.
2 Section 1510 provides a useful illustrative example for presenting callable debt. However this presentation is not permitted for retractable or mandatorily redeemable shares issued in a tax planning arrangement.
3 Paragraphs .13 and .14 of Section 1510 include specific requirements to this effect.