In January 2017, the Financial Accounting Standards Board (FASB) issued a Proposed Accounting Standards update as part of their Simplification Initiative. According to their Exposure Draft, the purpose of this initiative is to “identify, evaluate and improve areas of generally accepted accounting principles (GAAP), for which cost and complexity can be reduced, while maintaining or improving the usefulness of the information provided to users of the financial statements.”
The main category they’re focusing on is the balance sheet, as it displays separate classification of current assets and liabilities in the determination of working capital. So, what does this mean for a small business owner? Here’s how the FASB changes to debt classification might affect you:
Current vs noncurrent Liabilities
Liabilities are included on a company’s balance sheet to offset any assets, and are broken down into two classifications: current and noncurrent debts. Typically, these liabilities consist of money that a company owes to others for various business-related investments or loans. To fully understand the FASB changes to lease accounting and debt classification, it’s important to grasp the difference between current and noncurrent liabilities.
Current liabilities are debts the organization expects to repay within 12 months of the date on the balance sheet. Repayment of debts can be in the form of cash on hand or sale of current inventory. The main categories that make up current liabilities include Accounts Payable, Notes Payable, Employee Wages, Payroll Taxes and Unearned Income.
On the flip side, noncurrent liabilities are long-term debts the company doesn’t expect to settle soon. These debts are intended to be repaid in the months beyond the 12 months of the balance sheet date. Noncurrent liabilities are made up of Bonds Payable, Long-term Leases and Product Warranties.
FASB proposed changes
In the past, stakeholders have pointed out that lease accounting in a classified balance sheet is overly complex. So, with this update, FASB hopes to help cut these costs and reduce the amount of complexity that companies face when classifying liabilities as either current or noncurrent debts.
Debt classification is an important factor in the balance sheet, as it represents a company’s overall financial health. Too much short-term debt can be seen as a risk that investors may not want to take, as the company may not be able to shoulder any additional debt.
A change in the way debt arrangements are classified, either as current or noncurrent liabilities, is proposed to occur in the following ways, (as excerpted from the FASB Exposure Draft):
- The liability is contractually due to be settled more than one year (or operating cycle, if longer) after the balance sheet date.
- The entity has a contractual right to defer settlement of the liability for at least one year (or operating cycle, if longer) after the balance sheet date.
These changes aim to provide a less complex system for preparing financial statements, while simultaneously providing more consistent and transparent information for companies.
Future changes you can expect
Once the new FASB changes are put into effect, after receiving all feedback from stakeholders by May 5, 2017, the existing debt classification rules will be superseded by a principle that differs from the existing ones. This proposed update will shift classification of certain debt arrangements between noncurrent liabilities and current liabilities, as compared with the current rules.
One of the most significant changes expected involves short-term debt that is refinanced on a long-term basis, after the balance sheet date. In line with current guidance, short-term debt that is refinanced on a long-term basis is to be classified as a noncurrent liability, but with this new initiative, it’s to be classified as a current liability instead. The FASB changes would prohibit a company from considering future refinancing, when determining the classification of debt on the balance sheet.
What small business owners need to know
The FASB has decided that the classification of debt should be based on facts and circumstances that exist at the date of the balance sheet. This proposal intends to focus more on principles, such as what GAAP accounting is based on, rather than fact-specific rules, all still based on legal terms. In the event that a violation of a loan covenant has been waived before the financial statements are issued, the borrower can continue to classify the debt as a noncurrent liability.
This new proposal could help businesses show a more accurate and stable financial position, with the goal to avoid a vicious funding cycle. Decreased funding can cause a loan covenant violation, which results in a weaker financial standing. A weaker financial standing often results in less funding, and the new FASB debt classification hopes to help streamline this.