Debt Covenants | Advanced Accounting

Running Head: ADVANCED ACCOUNTING
ADVANCED ACCOUNTING
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Table of Contents
Introduction................................................................................................................................2
Literature Review.......................................................................................................................2
Debt Covenants......................................................................................................................2
Positive Accounting Theory...................................................................................................3
Conclusion..................................................................................................................................5
Reference....................................................................................................................................6

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Introduction
Debt covenants are the contracts in between firm and the creditor that usually limits
for some financial ratios, which may not be breached by company. Its projection is important
component of the financial model of company. Debt covenant is the restrictions or term
included in debt contract, which is designed for protecting lender’s interest. It includes
working capital ratios, dividend payout ratios and leverage ratios or restrictions to borrow
higher priority of debt (Bradley and Roberts 2015). Hence, this report aims to discuss
concepts of debt covenants in the context of positive accounting theory.
Literature Review
Debt Covenants
Debt covenants are the restrictions that the lenders such as investors, debt holders and
creditors put on the lending agreement for limiting the borrowers or debtor action. It can also
be described as agreement between firm and its lenders, under which firm will be operating
within certain rules set by lenders. It is also termed as financial covenants or banking
covenants. Basically, debt covenants does not places burden on the borrower, rather it aims
for aligning interest of agent and principal and solve the problems of agency between
borrower and holders of debt (Hollander and Verriest 2016). The control rights over
investment decisions of company rest with the shareholders, except in the situation when
company fails on principal payments of debt or breaching covenants, which is included in the
debt contracts. In either of the situations, creditors are given rights for accelerating payments
of loan or terminating agreements of loan. Hence, in the attempt for preventing these
outcomes, the creditors’ gains rather than having some influences over company and
acquiring certain control rights, which they could use for reshaping their policy of
investment. The violation of debt is breach of the contract. In case, when the debt covenant is

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being violated then depending upon severity, the lender can demand for penalty payments,
increases predetermined rate of interest, increase collateral amount, demand the full
immediate loan repayment and terminating the agreement of debt (Christensen, Nikolaev and
Wittenberg‐Moerman 2016).
Positive Accounting Theory
PAT is concerned with predictions of actions regarding accounting policies choices
by the firms and the way firms responds to proposed latest standards of accounting. This
theory helps in predicting choices, which management will be making in relation to their
accounting policies choices. The PAT takes view that organizations conducts their business
in a way that it maximizes their best interest. Further, firm is portrayed by contracts entered
by them. The contracts of firm with lenders, shareholders, employees and suppliers are
central to their operations. The company is inclined for keeping their costs of these contracts
as low as it is possible. The theory emphasizes company’s accounting policies choice is
motivated by keeping down the costs of contracts (Demerjian and Owens 2014).
The context of positive accounting theory is classified into three major hypotheses:
Bonus Plan Hypothesis: This hypothesis explains that the managers will use that
policies of accounting, which likely shifts the reported incomes from the future period
to current period. It is done for maximizing their personal compensation, as with the
help of reporting higher net income, the utility will get maximized through incentives
and bonuses (Demerjian 2017).
Debt Covenant Hypothesis: This hypothesis explains that the closer company is
compromising debt covenants, there will be more likely that management will be
using policies of accounting for deferring reported incomes from current to future

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periods. It is because the higher net income will be reducing probability of the
technical default on obligations (Deng et al. 2016).
Political Cost Hypothesis: This hypothesis explains that greater the firm’s cost fo
politics, there will be more likely that management will be using policies of
accounting for defer reported income from current to the future periods. This
particular hypothesis brings out politics into the accounting policies choice. The firms
that are highly profitable attracts media and the attention of consumer. This attention
creates increase in the taxes as well as other regulations (Denis and Wang 2014).
The PAT can be divided into efficient and opportunistic versions. The presentation of
these three hypotheses of PAT is in the opportunistic form. The managers chooses policies of
accounting for maximizing their own expected utility that is relative to their debt covenants,
bonus plan and the political costs. The management always tries to choose accounting
policies, which helps in minimizing their costs of contracts. The choice of these accounting
policies can be also be based on efficiency criteria. Both of these theories make same types of
forecast; hence, it becomes difficult for determining whether efficiency or opportunism is
driving policy change (Hollander and Verriest 2016).
The results have showed that managers would be able to change policies of accounting in
response to the problems of debt covenant, only in case, when it is assumed to be cost-
effective. The company that gets benefit opportunistically through the cost of substantial tax
from switching the policies of accounting, they chose not for doing so in the favor of more
efficient alternatives. Hence, it supports both efficient and opportunistic views of the
hypothesis and the analysis that is company specific is required for distinguishing between
these two views. Further, research have found that the net income is more linked with the net
returns than the cash flow. Moreover, the choice of managers regarding discretionary accruals

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serves for improving predictive value of the current earnings for predicting earnings of future
(Roberts 2015).
Conclusion
Therefore, this report concludes that debt covenant is the agreement, which stipulated
term and conditions of the loan policies that is between lender and borrower. This agreement
helps in giving lenders leeway for providing repayments of loan, while still protecting their
position of lending. Moreover, it is analyzed that debt covenants helps in playing wider role
in the corporate governance to control relationship between firms and lender and in
discussing the requirement for the debt contracts standardization. Further, this report has
analyzed that positive accounting theory is used for predicting and comprehending choice of
accounting policy, which firms make. This theory has introduced the way of merging market
theory with the economic consequences.

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Reference
Bradley, M. and Roberts, M.R., 2015. The structure and pricing of corporate debt
covenants. The Quarterly Journal of Finance, 5(02), p.1550001.
Christensen, H.B., Nikolaev, V.V. and Wittenberg‐Moerman, R., 2016. Accounting
information in financial contracting: The incomplete contract theory perspective. Journal of
Accounting Research, 54(2), pp.397-435.
Demerjian, P.R. and Owens, E.L., 2014. Measuring financial covenant strictness in private
debt contracts. SSRN Electronic Journal.
Demerjian, P.R., 2017. Uncertainty and debt covenants. Review of Accounting Studies, 22(3),
pp.1156-1197.
Deng, Y., Devos, E., Rahman, S. and Tsang, D., 2016. The role of debt covenants in the
investment grade bond market–the REIT experiment. The Journal of Real Estate Finance and
Economics, 52(4), pp.428-448.
Denis, D.J. and Wang, J., 2014. Debt covenant renegotiations and creditor control
rights. Journal of Financial Economics, 113(3), pp.348-367.
Hollander, S. and Verriest, A., 2016. Bridging the gap: the design of bank loan contracts and
distance. Journal of Financial Economics, 119(2), pp.399-419.
Roberts, M.R., 2015. The role of dynamic renegotiation and asymmetric information in
financial contracting. Journal of Financial Economics, 116(1), pp.61-81.