What are debt covenants?

3. Debt covenant violations and debt financial reporting

When a debt covenant is violated by the borrower, the lender has a range of alternative responses, including the following (non-exhaustive list):

  • Waive the violation and continue the loan
  • Waive the violation and imposition additional constraints
  • Require penalty payment
  • Increase interest rate
  • Demand immediate repayment of the loan
  • Increase collateral
  • Terminate debt agreement

A debt covenant violation represents a breach of contract. Lender’s response to the breach of contract usually depends on the severity of the breach as well as the terms of the debt agreement. When a debt covenant violation is not severe, usually lenders either waive the violation or imposition additional constraints on the borrower.

From the financial reporting perspective, when a company violates a debt covenant on a long-term debt, the company must reclassify the debt as short-term, unless the lender doesn’t have the right to call the immediate repayment of the loan. To escape this reclassification requirement, the company can obtain debt covenant waiver from the lender before the financial statements are issued.

To avoid a debt covenant violation, a borrower might try to manage its earnings. For example, many financial ratios used in debt covenants are affected by earnings (e.g., ratios based on EBITDA – earnings before interest, taxes, depreciation, and amortization): debt-to-equity, fixed charge coverage, etc. Nevertheless, to decrease the borrower’s incentive to manage earnings, the lender can specify in the debt agreement that the debt covenants must be measured using GAAP compliant financial statements.

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