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Companies routinely face debt covenants and occasionally these covenants are binding. That is, the company’s financial statements indicate that the covenant has been violated or is close to being violated. Managers have historically used various means to improve their reported numbers to avoid binding covenants, including adjusting accounting accruals, and making “real” operating changes such as decreasing certain discretionary expenses or cutting back on capital expenditures. What consequences might arise if the company focuses on managing reported numbers to avoid violating debt covenants? What parties are affected by such schemes?
Expert Answer
Debt covenants are restrictions listed out in debt arrangements to aid lender and to restrict activites of borrower.
To avoid violation of covenants, if managers try to adjust numbers reported in financial statements which means violations to covenants are keep a bay, however, at the cost of misrpesenting the numbers in financial statements at time. This affects the parties as below
Internal parties
1. Managers and Board: decision making is done based on the numbers published in financial statements. adjsuted numbers could lead to wrong decisions.
2. Costing and budgeting: manipulated information may lead to wrong costing decisions and flaws in budgets.
External parties
Investors: Investors highly rely on financial data of a company for their decision.
Shareholders: They take great amount of interest in the data presented to outer world.
Customers: Wrong information may lead to a fall in customer confidence in the company.
Govt Authorities: intentional misrepresntation of data would lead to wrong reporting to the tax authorities,
