Accounting Based Debt Covenants

Debt covenants, also called banking covenants or financial covenants, are agreements between a company and its creditors that the company should operate within certain limits. A covenant is an agreement or promise to do or not to do a particular thing, to enter into a formal agreement; a promise incidental to a deed or contract. The functional objectives guiding most covenants are full disclosure of information, preservation of net worth, maintenance of asset quality, maintenance of adequate cash flow, control of growth, control of management, assurance of legal existence and concept of going concern, and provision for lender profit or program goals. Debt covenants are agreed as a condition of borrowing. They may be changed if debt is restructured. The conditions agreed to vary. A company may, for example, agree to limit other borrowing or to maintain a certain level of gearing. Other common limits include levels of interest cover, working capital, and cash flow.

Covenants are of two types: affirmative and negative. Affirmative covenants include the following:

• Use the loan for agreed upon purpose

• Compliance with laws

• Rights of inspection

• Maintenance of insurance, properties, and records Negative covenants include the following:

• Limit on the total amount of debt

• Limit on the amount of investment and capital expenditure

• Limit on the size of dividend payments

Lenders make use of accounting numbers fixed charge coverage [i.e., Earnings before interest, taxes, depreciation, and amortization (EBITDA)/interest + debt due now + dividends + replacement capex] in debt agreements. Further, they also specify maintenance of a minimum current ratio. Debt covenants can impose quite heavy obligations - a company may well be forced to sell assets in order to stay within a debt covenant on leverage. In theory, breach of a debt covenant usually allows creditors to demand immediate repayment. This rarely happens in practice. The debtor is not usually in a position to make an immediate repayment. A breach of covenants, therefore, usually leads to a renegotiation of the terms of debt. The debt is likely to be renegotiated on worse terms as a quid pro quo for not demanding immediate repayment. Managers have an incentive to manage earnings when contract provisions are about to be violated.

Academic research provides evidence that firms make accounting choices to avoid violation of debt covenant provisions and the resulting costs of technical default. These studies indicate that defaulting firms make more accounting changes than nondefaulting firms. The decision by defaulting firms to change or not change accounting methods during the 3 years ending in the year of a technical default of debt covenants can be explained in part by the ability of the firm and by the incentives of the firm to make a change (Steven et al., 2004).

In order to prevent companies from meeting the requirements by adjusting their accounting practices rather than by genuinely maintaining the required level of financial health, debt covenants not only specify the numbers that should be met but also specify exactly how they should be calculated for the purposes of the debt covenant. This means that if a company breaches, or is in danger of breaching its debt covenants, not only does this indicate that the company is not financially strong but also indicate that the problems are likely to become worse as lenders react.

ó.ó.5 Management Compensation

In many companies, top management compensation is tied to one or more measures of performance. Quite often earnings before interest and tax or profit after tax or a ratio such as return on equity is used to determine bonus. Clearly, managers have an incentive to distort numbers to maximize their compensation. Of course, it is possible for the board to see through such behavior, which limits the scope for manipulation.

6.6.6 Capital Market Considerations

As demonstrated in the iSoft example presented at the beginning of the chapter, the stock market reacts to financial statement data and changes in accounting policy. Consequently, managers have an incentive to choose policies that increase profits and/or cash flows. This can, at least in the short run, can prop up the stock price. The incentive to keep the stock price up is more when a company's strategy is to grow via acquisitions paid in stock.

6.6.7 Tax Considerations

Managers may also make reporting choices to trade off between financial reporting and tax considerations. As pointed out earlier, depreciating an asset by an accelerated method results in relatively lower taxes early in the asset's life. So managers can reduce taxes by switching from straight line to accelerated methods. Likewise, the LIFO (last-in-first-out) method results in lower profits and, hence, taxes when input prices are rising.

6.7 Performing Accounting Analysis

The following steps are involved in performing an accounting analysis:

• Identify key accounting policies: All accounting policies are not significant in all industry groups. Analysts must prepare a list of all key accounting policies relevant to the company and industry in which the company operates, and make an estimate of the impact of key accounting policies. In the airlines industry, for example, accounting for long-lived assets and depreciation are important. Likewise, how inventory is accounted for is important in retailing.

• Evaluate accounting policy and the quality of financial disclosure: Analysts can (and must) compare the policies of a firm with those of peer companies to find out the firm's incentives in choosing the policies.

• Make adjustments for accounting distortions by restating balance sheet, income statement, and cash flow statement numbers.

6.8 Financial Analysis

Financial statements reflect the nature of the industry, the company's competitive position, and policies. The financial statements of Amazon.com, for example, would be different from those of more traditional brick and mortar companies. To begin with, Amazon's business model is such that it carries very little inventory compared to land-based retailers; it has little or no receivables (it receives money before it ships books) and so on. Likewise, Airline firms invest heavily in plant and equipment. Consequently, depreciation would be high. Software firms derive much of their value from future growth options and intangibles like human capital and indirect costs of bankruptcy are high. So they carry little or no debt because of lack of hard asset collateral. The objective of financial analysis is to assess the performance of a firm in relation to the stated goals, strategy, and those of competition. There are two principal methods of financial analysis:

• Ratio analysis

• Analysis of cash flow statements

We discuss ratio analysis in this chapter. The subsequent chapter is devoted to analysis of cash flow.

6.8.1 Ratio Analysis

A ratio is a relationship between two numbers. Managers and analysts use a variety of balance sheet and income statement ratios to assess the financial health of a company. These ratios can be classified as follows:

• Liquidity ratios

• Coverage ratios

• Leverage ratios

• Operating ratios

• Profitability ratios

In the News

Investor anger surfaced last week after Red Hat, Inc., changed how it books software subscription revenue, setting the stage for courtroom battles on whether company officials profited from the switch in accounting methods (Bab-cock, 2004). Investors filed six class-action lawsuits against the Linux supplier 2 days after it said it would restate earnings and move to a daily, instead of monthly, method of accounting for its software subscription revenue. The suits charge company executives with violating various infractions of securities laws and misleading of investors. One suit charged that company officials profited from the sale of stock between March 19,2002, and last Monday, when the monthly accounting method was in force. Red Hat did not respond to a request for a comment. Red Hat shares, which hit a 4-year high of $29.06 in June, closed at $15.15 on Friday, down $5.34 for the week, or 26%. Until Thursday, when shares rose slightly, the stock had been on a slide since the unexpected resignation of chief financial officer (CFO) Kenneth Thompson on June 14, followed by lower-than-expected earnings projections on June 17. Monthly accounting of subscription revenue is more common among software companies than daily accounting. Daily-based accounting is a "more-conservative method," says Dion Cornett, Managing Director at the equity-research firm Decatur Jones Equity Partners LLC. The shift to daily from monthly revenue accounting for subscriptions has the effect of moving revenue that was previously recognized in the first quarter of a subscription into the final quarter of the agreement, Red Hat officials said. The firm's auditors, Price-waterhouseCoopers, recommended the change in June.

Exhibit 6.1 Time series of Return on Equity (ROE) for Toyota

Year

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