Most companies have debts. After all, contracting a loan is a normal and healthy way to obtain the necessary resources to grow your business. Since the debt is long-term and the reimbursement plan aligned with your financial capabilities, everything is under control, right? Wrong.
Classification of long-term debt as current liability is becoming more and more common in financial statements. Given that in their form, these liabilities are obviously long-term in nature, this treatment often raises questions from users of these financial statements and can cause significant problems for businesses.
Classification of long-term debt as current will have a major impact on the appearance of the balance sheet of an entity and it will worsen the financial ratios. This may cause the company to experience solvability issues, difficulties in finding new investors and problems when negotiating with suppliers. It may even cast doubt on the capacity of the entity to survive in the long run. Therefore, it can have a great impact on the decisions made by financial statements users and careful thought and consideration should be given to this scenario.
When is long-term debt classified as a current liability?
At a minimum, classification of long-term debt as a current liability can occur in three of the following situations:
- The long-term debt is callable or payable on demand (even though a schedule of repayments over a number of years exists).
- The long-term debt is renewable within one year from the balance sheet date.
- There was a covenant violation as at the balance sheet date.
If the lender 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, without considerations to whether the lender has the intention to demand repayment in the short term. The intention of the lenders is not considered in this assessment as Canadian Accounting Standards for Private Enterprises clearly indicates. That classification of a debt on the balance sheet is a function of the facts existing at the balance sheet date, rather than on expectations regarding future refinancing or renegotiation.
How to avoid long-term debts becoming current liabilities
In such a scenario, there are only limited ways to classify the debt as long-term and to avoid the problems caused by its classification as a current liability.
1. Obtain a waiver from the lender
This waiver should clearly specify that the lender has waived the right to demand repayment of the debt for a period of more than one year. It’s important to remember that due to legal considerations and risk exposure, lenders are more reluctant to issue waivers now than in the past. This results in a greater number of long-term debts being presented as current liabilities.
2. Refinance the debt on a long-term basis
The refinancing should take place prior to the issuance of the financial statements. This can take the form of a renegotiation of the debt with the lender to postpone its payment or remove the payable on demand clause.
An ounce of prevention is worth a pound of cure
The classification of long-term debt as current liability is truly a situation where an ounce of prevention is worth a pound of cure. By working closely with your financial advisor to identify these cases prior to the issuance of the financial statements, you will give yourself time to find solutions and manage these problems before they get out of control.