Debt Covenants

Topics: Asset, Balance sheet, Debt Pages: 6 (1985 words) Published: February 17, 2012
Introduction

When accounting standards change, the impact those changes have on debt contracts is influenced by virtue of the 'rolling' (floating) or 'frozen' generally accepted accounting principles (GAAP) applied to the debt covenants within the contracts. Positive accounting theory (PAT) assumes managers will act in self interest once contracts are in place (Deegan 2009, p. 292) and this may or may not lead managers to lobby standard setters in support for or against draft changes to standards or the introduction of new standards based on this premise.

Discussion

Debt contracts are instruments used by lenders to reduce risk and the agency costs of debt (the costs associated with the divergent behaviour of the borrower in PAT) and can be explained from an efficiency perspective (Deegan 2009 p.292). The positive accounting theory of debt assumes borrowers (managers) will use accounting methods to avoid repaying the debt and explains that borrowers may take action that will increase the risk to lenders by incurring more debt or undertaking risky business decisions (Deegan 2009). To reduce their risk lenders will include debt covenants within contracts. Deegan (2008 p. 1357) defines a debt covenant as, '...a restriction within a contract on the operations of a borrowing entity'. Restrictions may be in the form of restricting new debt that would mean existing lenders will compete for assets, placing restrictions on the issue of dividends, placing conditions on the disposal, revaluation and treatment of assets, specifying minimum ratios such as debt to tangible assets and debt to equity (Deegan 2009 p. 293, p. 205) and so on defining minimum accounting based requirements (Deegan 2009, p. 291). Changes to standards and rules will affect the accounting measurements and calculations relating to the particular covenant in place and potentially expose the borrowing entity to a breach of covenants or technical default. One example of potential breach due to changes in standards was demonstrated when standard setter, the Australian Accounting Standards Board (AABS) amended the standards accounting for intangible assets. For example, internally generated intangible assets, such as goodwill previously capitalised, were no longer able to be capitalised (unless acquired as part of a business combination) (AASB 136). The resulting write down to the income statement of existing intangible assets returned a reduction in assets affecting debt ratios and in turn the debt covenants requiring a minimum level of debt ratio. Of course, only existing debt covenants that were in place at the time based on rolling GAAP would have been affected.

Rolling GAAP refers to '...where an accounting-based contractual arrangement is to be calculated according to the accounting rules in place at the reporting date...' of the entity (Deegan 2009 p. 280). Those standards in place at the reporting date may differ from the standards in place at the time the contract was originally negotiated. (Deegan 2008: Deegan 2009). Frozen GAAP, on the other hand, is where the contractual agreement will be calculated according to accounting standards in place at the time the contract was originally negotiated (Deegan 2008: Deegan 2009). Therefore, the superseded accounting rules are used without regard for changes made to standards and the effects those changes have on the debt contract calculations. When agreements or contracts are negotiated by managers, rolling and or frozen GAAP are sometimes stipulated within a contract in relation to debt covenants with the effect on future calculation of the contracts characterised by the type of GAAP applied.

Rolling and frozen GAAP applied to accounting-based debt covenants of debt contracts will determine the future calculation of the agreements in place. When accounting standards and legislation change, measures of assets and revenue (for example) will be affected. Frozen GAAP covenants will not be...

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