Question

Accounting Theory

You have been recently appointed as a lending officer in a large bank. The bank is concerned about lending in the current economic environment, where there has been an economic downturn. Prepare a report outlining what agency problems the bank should be concerned with and how debt covenants in debt agreements can be used to reduce those problems. Also explain how accounting numbers can be used to assist in the process?

Required: Using the reference materials available on the internet and text book, research the topic and prepare a report for the bank fully referenced up to 500 words.

Note: This references to Financial Accounting

Answer 1

POINTS TO BE INCLUDED WHILE PREPARING THE REPORT

• Economic Downturn/Recession is a situation where people require more liquidity with decrease in the supply of credit, leading to a increase in interest rates.
• But, with the intervention of the country's central bank's policies we can see falling interest rates.Here the agency problem comes into play, it is a conflict of interest between 2 parties, where one party is expected to act in another's best interest.
• Debt covenants is an agreement between the lendor and the buyer usually set in the best interest of both parties. The examples of debt covenants are :
  • Limiting the company from availing further loans from other lenders as it will increase the chance of default.
  • Restriction of payment of dividends as it would empty the money to pay off the debts.
• Debt covenants can be :
  • Positive ( stating what the borrower must do) such as provision of yearly audited financial statements.
  • Negative ( Restrictions on what they cannot do) selling assets or borrowing money.
• Violation of debt covenants leads to immediate repayment or increase in the amount of predetermined interest.