A FASB proposal could render obsolete a valuable financing option for health care entities known as variable-rate debt obligations (VRDOs).
Under current GAAP, VRDOs often are presented as noncurrent liabilities; under the FASB proposal they would be presented as current liabilities.
In September, FASB issued Proposed Accounting Standards Update (ASU) (Revised), Debt (Topic 470): Simplifying the Classification of Debt in a Classified Balance Sheet (Current versus Noncurrent).
The Proposed ASU applies to for-profit and not-for-profit organizations that prepare classified balance sheets. It is meant to improve the guidance for determining whether debt should be classified as a current or noncurrent liability.
FASB maintains that the current guidance on classifying debt can be difficult for preparers and auditors to navigate and for financial statement users to understand. Current GAAP defines current liabilities as debts the organization expects to repay within one year, or the operating cycle, if longer, and noncurrent liabilities as debts an organization intends to repay after one year, or the operating cycle, if longer. While these rules seem straightforward, there is additional guidance for other debt types such as debt that includes covenants or debt with subjective acceleration clauses that is more complex and can require additional effort on the part of preparers, auditors, and users to understand and follow.
The Proposed ASU tries to simplify current GAAP by redefining debt as noncurrent when either of the following criteria is met as of the balance sheet date:
- The liability is contractually due to be settled more than one year (or operating cycle, if longer) after the balance sheet date; or
- The entity has a contractual right to defer settlement of the liability for a period greater than one year (or operating cycle, if longer) after the balance sheet date.
FASB believes that the new classification rules and their associated amendments will provide greater transparency and understanding to financial statement users about noncurrent debt arrangements. The proposal acknowledges that the new classification rules will result in shifts between noncurrent and current liabilities for matters involving waivers of debt covenant violations, contractual grace periods, instruments that require settlements in shares, and other matters. However, the new guidance and resulting classification shifts may not contribute to FASB’s simplification objectives of reducing cost and complexity and increasing financial statement transparency for all debt types, including VRDOs.
Many not-for-profit health care organizations use VRDOs, which are bonds with interest rates that are reset on a daily, weekly, or monthly basis. The bonds can be redeemed at par by the investor through a “put” or “tender” feature on the reset dates. Dealers called remarketing agents are responsible for adjusting the interest rates on reset dates at the lowest rate that will permit the sale of the VRDO at par. Remarketing agents are also responsible for finding a purchaser for tendered bonds. A situation called a “failed remarketing” occurs if the remarketing agent cannot find a buyer. When this occurs, one option is for the remarketing agent to buy the bonds and hold them until they can find other buyers, which is common practice. The other option is for the issuer to draw on a liquidity facility, such as a letter of credit (LOC) or a standby bond purchase agreement (SBPA) to repurchase the bonds. A liquidity facility is typically used as a last resort in times of stressed market conditions because of the associated fees and penalties.
The issuance of VRDOs resulted in investment vehicles liked by investors because the related investments are generally exempt from state and local taxes, offer lower risk through LOCs or SPBAs with higher credit ratings, and provide liquidity via the put options.
Issuers also benefit from VRDOs because despite having the redemption or put option, they are typically issued for long-term financing with maturities ranging from 20 to 30 years. Remarketing strategies and contractual linkages to LOCs have historically ensured the long-term nature of the debt. Hospitals and other health care facilities use VRDOs to generate the capital needed for optimally delivering modern health care practices.
GAAP currently allows organizations to classify VRDOs as noncurrent liabilities if they contractually enter into a financing arrangement such as an LOC or SBPA in conjunction with the tax-exempt offering. The Proposed ASU on simplifying the classification of debt would preclude an entity from considering such financing arrangements in determining the classification of debt. The revised proposal states that the guidance would apply prospectively to all debt arrangements that exist at the date of adoption and all arrangements entered into after that date. FASB will determine the effective date after consideration of the feedback received on proposed amendments.
The Proposed ASU regarding VRDOs seems unreasonable because the option to finance via a VRDO backed by an LOC or SPBA has been seen as interchangeable with other long-term financing options such as direct purchase, floating-rate notes, or fixed-rate bonds. It is clearly intended to be a long-term debt vehicle in practice. The new simplification rules want to steer away from “intent” and move to a more “contractual” basis for determining classification, and the reasons for classifying VRDOs as noncurrent debt pertain to the contractual obligations of remarketing and the contractual linkage of the debt obligation with an LOC, SBPA, or other liquidity facility. This integrated financing structure essentially embeds the LOC or SBPA as part of the financing arrangement.
Additionally, a consequence of the proposed guidance seems to be that debt under such an arrangement would be classified as noncurrent only after a failed remarketing, which seems counterintuitive to the driver of such an event. Under the terms of a VRDO, the LOC is used to pay the par value plus any accrued interest only if there is a failed remarketing. While this extends the long-term nature of the debt, making it appropriately classified as noncurrent, it appears that the Proposed ASU contradicts its proposed rule and considers the LOC in this situation. Further, it ignores the notion that a successful remarketing preserves the long-term nature of the bond because the debt itself is not “reissued” when it is remarketed to a new investor. It remains outstanding and should be considered a long-term obligation. The proposed reclassification is also contrary to FASB ASC Paragraph 210-10-45-12, which discusses how current liability classification is not intended to include long-term obligations incurred to provide increased amounts of working capital for long periods.
As proposed, the portion of the Proposed ASU requiring short-term classification for VRDOs could unduly impact and skew financial metrics of health care organizations used by key decision-makers, complicate peer comparisons, require possible debt covenant amendments or waivers, and possibly result in increased costs from having to extinguish or restructure current debt arrangements and replacing it with higher-cost debt.
The Proposed ASU could have other far-reaching implications. The proposed current classification of VRDOs may cause many financial statement users to be misinformed about an organization’s true working capital and liquidity, and its ability to continue as a going concern. An organization that was once quite solvent may appear to not be as solvent, or even insolvent, if FASB implements the proposed simplification rule. Management of health care organizations will have to spend additional time working with bond rating agencies, auditors, and others to help them understand the true financial stability of the entity. Furthermore, it may cause health care systems to discontinue the use of a well-proven and cost-effective method of long-term financing with the combination of a VRDO and an LOC or SBPA. This increases administrative burden, including having to evaluate new financing options and consider unwinding arrangements already in place, and could result in substantial incremental costs, including loss on early extinguishment of such arrangements and higher future interest costs. The proposal could also have negative financial and operating implications for financial institutions that issue LOCs or SBPAs, institutions that provide underwriting services, and investors.
The full proposal is available at FASB’s website, and the board is accepting comments through Oct. 28.
— Norman Mosrie, CPA, FHFMA, CHFP, is a partner with DHG Healthcare and chairs the AICPA Health Care Expert Panel and the Healthcare Financial Management Association Principles and Practices Board. Nancy Lankton, CPA, CISA, Ph.D., is associate dean for Accreditation and Strategic Initiatives at Lewis College of Business at Marshall University. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com or 919-402-2112.