Debt Covenants

Topics: Asset, Balance sheet, Debt, Financial ratio, Loan, Contract / Pages: 6 (1985 words) / Published: Feb 18th, 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



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