Debt Covenants | Advanced Accounting

Running Head: ADVANCED ACCOUNTING
ADVANCED ACCOUNTING
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1ADVANCED ACCOUNTING
Table of Contents
Introduction................................................................................................................................2
Literature Review.......................................................................................................................2
Debt Covenants......................................................................................................................2
Positive Accounting Theory...................................................................................................3
Conclusion..................................................................................................................................5
Reference....................................................................................................................................6

2ADVANCED ACCOUNTING
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