Why do loan agreements often contain covenants tied to accounting numbers? Are there any disadvantages to this common practice?

Question

What will be an ideal response?

Answer 1

Accounting uses a set of generally accepted principles to measure a wide array of business activity.  It is hard to conceive of some action that management might take that does not directly, or indirectly, affect accounting numbers. Thus, accounting numbers are a convenient way to monitor management's actions or measure their success at running the company. Because the financial statements are audited by independent accounting firms, lenders can be assured that the reported numbers are relatively free from error and material misstatements. In addition, the borrower (company) must produce financial statements anyway, so there is no added out-of-pocket cost to using these same statements as a basis for loan agreements. There are, however, some disadvantages to using accounting numbers in loan covenants. Even though the financial statements are audited, management still has some discretion over the reported amounts and note disclosures. Opportunistic reporting can never be completely ruled out. Examples include voluntary accounting method changes and changes in accounting estimates. Another potentially negative factor to consider is that accounting-based loan covenants can be influenced by mandatory accounting changes imposed by the FASB or other regulatory group. Lenders may feel that such changes detract from the ability of accounting numbers to accurately portray changes in a borrower's credit risk. Also, mandatory accounting changes may cause borrowers to be in technical violation of debt covenants even though there has been no real change in underlying default risk.