by Glenn Cheney
Norwalk, Conn. — In a continuing effort to quickly converge at least a few U.S. standards to international standards, the Financial Accounting Standards Board is hammering out a proposal on liability classification. The proposal is likely to redefine current liability, but in so doing, it may complicate accounting at small businesses.
The proposal tightens the definition of current liability to require the use of a company’s balance-sheet date as the cutoff date for determining whether a liability is current. Existing generally accepted accounting principles allow companies to use any date up to the issuance of the relevant financial statement.
The tightened definition avoids exceptional situations in which current liabilities can be considered non-current, and non-current liabilities can be considered current.
While the tightening helps eliminate many such exceptions, it can also lead to misleading financial statements, especially in the case of small companies. For no reason other than the technical difficulty of preparing year-end financial statements, small companies can find their long-term debt suddenly converted to a current liability — a situation that they may not recognize until after their audit has been performed. Though the debt may be refinanced, the financial statement may not reflect that fact in the balance sheet.
Such a situation is less likely in a public company that has been issuing quarterly statements throughout the year. Public companies are more likely to see the impending expiration of a debt covenant or the final year of a long-term debt, when it converts to current liability.
Nonpublic companies tend to wait until after the end of the year to calculate their balance sheets, belatedly discovering the effect of debt becoming a current liability. Under current standards, the company could arrange and book the effects of refinancing before issuing the financial statement.
Stephen McEachern, chairman of the American Institute of CPAs’ Technical Issues Committee and managing partner of Austin, Texas-based Fitts, Roberts & Co., is concerned about the effects of the tentative definition. “The TIC has been vocal about this. It’s an issue that is important to small business, one that is going to negatively impact their dealings with their lenders,” he said. “It’s going to put small businesses in a precarious position of not being in compliance with their debt covenants. It’s been treated as a non-controversial issue, but I think that small business interests have been inadequately considered in that determination.”
FASB project manager Jeffrey Johnson acknowledged that the new definition could lead to such a situation, but he noted that it could be avoided.
“The board has tentatively decided that if a company is going to classify something as long-term because it has a refinance agreement in place or a waiver or grace period, it has to have those in place at the balance- sheet date in order to be able to consider them as long-term,” Johnson said. “We’ve been hearing, informally, from small businesses that it will be difficult for them to know that they have a need for a waiver until after the balance-sheet date.”
Johnson pointed out that while the problem is real, it is mollified by the board’s encouraging companies to disclose events that happen after the balance-sheet date and their impact on liquidity.
The project on liability classification is the fifth in a series that aims to converge FASB and IASB standards. Four exposure drafts were issued in December. The board had hoped to issue the fifth early this year, but is now considering expanding the scope of the project.
“The board asked us to potentially expand to consider working capital as a whole,” Johnson said. “We’re doing research to see how the working capital definition gets applied in practice and what exactly we’re getting ourselves into.”
Working capital is currently defined in Accounting Research Bulletin 43 under an operating cycle concept in which assets are considered current if they are expected to be converted to cash during the operating cycle, and liabilities are considered current if they are expected to require the use of current assets to settle them.
In its initial research, FASB staff is talking with companies that have operating cycles of more than a year. ARB 43 requires the use of operating cycles to define what is current. The board is considering requiring a standard annual cycle. Johnson said that the board did not know how many companies were on cycles of more than a year or how changing to an annual cycle would affect them.
International Accounting Standard 1 deals with working capital and uses the notion of operating cycles. Johnson said that any FASB move away from the use of operating cycles would be contrary to the intent of convergence, unless the international board later decided to converge with FASB’s standard. He added, however, that it was much too early to speculate on the direction his board will take if it expands the scope of the project.
Depending on the extent of any expansion of scope, an exposure draft of a new standard may be issued as soon as March or sometime later in the second quarter of 2004.
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