The FASB’s Accounting Standards Codification defines debt in the Master Glossary as “A receivable or payable (collectively referred to as debt) represents a contractual right to receive money or a contractual obligation to pay money on demand or on fixed or determinable dates that is already included as an asset or liability in the creditor’s balance sheet at the time of restructuring.” Interesting. The Codification has an entire section titled “Debt”, but the definition of debt is confined to the guidance covering debt restructuring. Don’t bother looking in the debt section for a definition. There’s none.
What about the concept statements? Well, they are not authoritative, but perhaps they might be helpful. Here’s the closest thing to a definition that I could find in Statements of Financial Accounting Concepts No. 6, Elements of Financial Statements a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2). Paragraph 96 states, in part, “Most liabilities presently included in ﬁnancial statements qualify as liabilities under the deﬁnition in paragraph 35 because they require an entity to sacriﬁce assets in the future. Thus, accounts and notes payable, wages and salaries payable, long-term debt, interest and dividends payable, and similar requirements to pay cash so obviously qualify as liabilities that they need no further comment.” Super.
We appear to be in the realm of “general accepted accounting principles” where the definition of debt is generally understood. It’s a curious place to be since the Codification clearly states that if it’s not in the Codification, it is not authoritative. So, the Codification is authoritative, but a major element, and a complicated one at that, has no authoritative definition. Really something when you stop and think about it.
But, let’s not waste any more time. We all know what debt is. Here’s my definition:
Debt is an amount owed by one party to another party. Debt is a subset of the general category ‘liabilities’. Debt can be evidenced by a loan note, a bond, a mortgage, commercial paper, or really any other form of agreement that has stated repayment terms, and perhaps provides for other terms such as interest rate, collateral, events of default, reporting requirements, financial covenants, restrictive covenants, and a whole host of other features.
I think the term ‘evidenced’ is important. That implies an executed agreement. I recall learning something about evidence of an agreement between parties in commercial law. The statute of frauds requires a written agreement when the amount in question is over $500. Of course, it’s really up to the courts to decide on a case-by-case basis. But we accountants like things neat and clean. We like to have a written, signed agreement. In the absence of a written, signed agreement, we may still have an obligation, but let’s throw that into the general class of things called liabilities, and confine ‘debt’ for purposes of navigating the accounting standards to mean ‘an amount owed by one party to another evidenced by a written agreement with stated repayment terms and perhaps some other terms as well’.
The purpose of this section is to make sense of the guidance covering debt. I will assume that you, the visitor to this site, have an accounting degree, a finance degree or are otherwise familiar with the term ‘debt’. Intermediate accounting does an excellent job of covering debt in general. This is a dive into the details. Onward.
Guidance applicable to debt can be found throughout the Codification, though primarily in Topic 470. Navigating the guidance begins with understanding the hierarchy as it applies to debt. Here’s the hierarchy at a high level:
- Plain vanilla debt – It’s not covered in the Codification. This is ‘generally accepted’ in the same way that common stock is always ‘equity’. A straight forward debt instrument devoid of all the bells and whistles that might pull in the accounting guidance that follows. If there’s no stated interest rate, then you do have the matter of imputing interest to deal with. And if issued at a discount or premium, then there’s amortization to content with. And let’s not forget financing costs. But all of these are matters that fall into the category of ‘generally accepted’ when it comes to debt, or that are the result of ancillary guidance in the Codification. I place this at the top of the hierarchy primarily because a) there is no specific guidance in the Codification and b) it is very unlikely that anyone would voluntarily elect the fair value option of ASC 825 (that’s next) for a plain vanilla debt instrument.
- ASC 825, Financial Instruments – This Topic provides the fair value option of accounting for certain financial instruments. If the option is elected (on an instrument-by-instrument basis), then all of the other recognition guidance applicable to debt, with the exception debt classification in a classified balance sheet, is effectively nullified.
- ASC 480, Distinguishing Liabilities from Equity – This topic addresses debt cleverly disguised as equity. Instruments that fall within the scope of ASC 480 have specific characteristics.
- ASC 815, Derivatives and Hedging – This Topic is not specifically applicable to debt and could arguably come ahead of ASC 825 in the hierarchy. I placed it here because ASC 825 is an election that would make the analysis under ASC 815 unnecessary. And, to further confuse, ASC 815 does not really cover a freestanding debt instruments; rather, its impact is, well, derivative. All those weird features in your debt agreement, or in related documents, must be analyzed as possible embedded derivatives. If you have a number of embedded derivatives (which must be bifurcated and accounted for apart from the debt instrument at fair value) it is possible, for a number of reasons but primarily cost, that you will want to make a fair value election for the entire instrument. It is also possible that you will encounter an embedded feature whose fair value is not reliably measurable. In this case, fair value accounting for the entire instrument is forced upon you. In either case, once the entire instrument is accounted for at fair value, you have nullified other GAAP as in ASC 815 above. There are other situations that are more granular. For example, a conversion option in convertible debt is determined to be an embedded derivative under ASC 815, then the beneficial conversion feature accounting under ASC 470 would not apply. For these reasons and quite a few others, ASC 815 comes ahead of ASC 470.
- ASC 470, Debt – Yes, the debt section itself comes in fifth in the hierarchy. The reason is actually very simple. ASC 470 does cover debt, but it covers very specific debt. Namely, the following:
- Generally – Short-term obligations expected to be refinanced as long-term; due on demand loans; callable debt; sales of future revenue; increasing rate debt; debt that include covenants; revolving credit agreement subject to lockbox arrangements and subjective acceleration clauses; indexed debt; debt with conversion and other options; interest forfeiture; debt provisions that permit the holder to alter terms; conversion upon exercise of a call option; debt issued to nonemployees for goods and/or services; own-share lending arrangements; cash conversion options
- Specifically – Participating mortgage loans; product financing arrangements
- Special situations – Modifications and extinguishments; troubled debt restructuring
- Industry specific – Extractive activities (oil and gas); financial services (depository and lending, and insurance); health care; not-for profit organizations; real estate; regulated operations
I’ll cover each level and much of the specifics within each level in posts and articles to come. The equity-linked transaction analysis tool addresses ASC 825 and ASC 815, and the beneficial conversion feature component of ASC 470, in the context of equity-linked instruments. Beneficial conversion feature accounting is also covered in detail on the beneficial conversion feature page.