Current Obligations Expected to Be Refinanced

Per FASB 6, current obligations that an enterprise intends and is able to refinance with long term debt have different reporting requirements.

Learning Objective

Explain why a company would refinance a debt

Key Points

Refinancing may refer to the replacement of an existing debt obligation, or current liability, with a debt obligation under different terms.
The most common type of debt refinancing occurs in the home mortgage market. Reasons to refinance include to obtain a better interest rate; to consolidate current debt; to free up cash and reduce periodic payments; and to reduce debt risk.
Calculating the up-front, ongoing, and potentially variable transaction costs of refinancing is an important part of the decision on whether or not to refinance, since they can wipe out any savings generated by the new loan terms.

Terms

closing fees
a variety of costs associated with the transaction (above and beyond the price of the asset itself) and incurred by either the buyer or the seller. These costs are typically paid at a future point in time, known as the "closing" when title switches hands.
non-recourse debt
a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the collateral.
recourse debt
a debt that is not backed by collateral from the borrower.
current replacement cost
the amount that an entity would have to pay to replace an asset at the present time, according to its current worth

Full Text

Definition of Refinancing

Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by the type of debt involved and is based on several economic factors such as:

the inherent and projected risk of the asset(s) backing the loan,
the financial stability of the lender,
credit availability,
banking regulations,
the borrower's credit worthiness, and
the borrower's net worth.

If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring. The most common type of debt refinancing occurs in the home mortgage market.

Deciding to refinance debt can be a balancing act between the funds requested and the interest rate charged on the funds.

Refinanced debt must be finalized and the new loan terms approved before reporting it and replacing it for the old debt in the liability section.

Reasons to Refinance Debt

A loan or other type of debt can be refinanced for various reasons:

To take advantage of a better interest rate or loan terms (a reduced monthly payment or a reduced term)
To consolidate other debt(s) into one loan (a potentially longer/shorter term contingent on interest rate differential and fees)
To reduce the monthly repayment amount (often for a longer term, contingent on interest rate differential and fees)
To reduce or alter risk (e.g. switching from a variable-rate to a fixed-rate loan)
To free up cash (often for a longer term, contingent on interest rate differential and fees)

Risks of Refinanced Debt

Calculating the up-front, ongoing, and potentially variable transaction costs of refinancing is an important part of the decision on whether or not to refinance. If the refinanced loan has lower monthly repayments or consolidates other debts for the same repayment, it will result in a larger total interest cost over the life of the loan and will result in the borrower remaining in debt for many more years. Most fixed-term loans are subject to closing fees and points and have penalty clauses that are triggered by an early repayment of the loan, in part or in full.

Penalty clauses are only applicable to loans paid off prior to maturity and involve the payment of a penalty fee. The above-mentioned items are considered the transaction fees on the refinancing. These fees must be calculated before substituting an old loan for a new one, as they can wipe out any savings generated through refinancing.

In some jurisdictions, refinanced mortgage loans are considered recourse debt, meaning that the borrower is liable in case of default, while un-refinanced mortgages are non-recourse debt.

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