Question

Companies routinely face debt covenants and occasionally these covenants are binding. That is, the company’s financial statements indicate that the covenant has been violated or is close to being violated. Managers have historically used various means to improve their reported numbers to avoid binding covenants, including adjusting accounting accruals, and making “real” operating changes such as decreasing certain discretionary expenses or cutting back on capital expenditures.

a. How do accounting accrual adjustments affect covenants that require minimums for retained earnings or for certain ratios such as the current ratio? Are those effects permanent?

b. How do real operating changes affect covenants that require minimums for retained earnings or for certain ratios such as the current ratio? Are those effects permanent?

c. What consequences might arise if the company focuses on managing reported numbers to avoid violating debt covenants? What parties are affected by such schemes?

Answer 1

The accounts are prepared based on accrual system of accounting. Hence, the financial data is prone to deviate a little than the actuals as the financial statements are prepared based on some estimates and assumptions. The effects of these in the financial statements are not permanant. The ratios derived are only provisional in nature.

The real operating changes in the statements affect the covenants permanantly. These are changes which are actual figures and hence they affect the ratios materially as the determined out of these figures are actual ratios determining the actual financial position.

If the company focusses on manipulations for reporting of the financials just to avoid the violation of debt covenants, it would present a wrong image of the financial position of the company. The stakeholders will be deeply affected by this act as they will be provided the wrong financial inormation which shall also not be ethical on the part of company.