Reading 39: Long-Term Liabilities and Leases LOSb习题精选 2010, statements, following, regarding, strategic

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LOS b: Explain the role of debt covenants in protecting creditors by restricting a company’s ability to invest, pay dividends, or make other operating and strategic decisions.

Larry Purcell, an entry-level fixed income analyst at Knowlton & Smeades LLC, was discussing debt covenants with his supervisor, Andy Holzman. During the meeting Purcell made the following statements regarding bond covenants:

Statement 1: If a firm violates any of its debt covenants, the company will immediately go into bankruptcy and the creditors of the firm will take over the liquidation of its assets.

Statement 2: Debt covenants are important in evaluating a firm’s credit risk and to better understand how the restrictions of the covenants can affect the firm’s growth prospects and choice of accounting policies.

With respect to these statements:

A) only one is correct.

B) both are incorrect.

C) both are correct.

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Lenders and other creditors use debt covenants in their lending agreements to restrict the activities of the debtor that could adversely impact the creditors’ position. If any bond covenant is violated, the firm is in technical default on its debt. The creditors can demand payment of the debt, however, the terms are generally renegotiated. As such, the company does not automatically enter into bankruptcy and have its assets liquidated by the creditors.

 

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Which of the following statements regarding bond covenants is least accurate?

A) Bond covenants are typically disclosed in the footnotes to the financial statements.

B) All bond covenants are accounting-based, and affect a firm’s choice of accounting policies.

C) Bond covenants are important in valuing a firm’s equity including its growth prospects.

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An analyst or any end-user of financial statements should carefully review the information on a firm’s bond covenants in order to evaluate the firm’s debt securities and equity securities. The covenants are typically disclosed in the footnotes of the firm’s financial statements. However, not all bond covenants are accounting-based. For example, payoff patterns including sinking fund agreements and the priority of claims are not accounting-based and should not affect the firm’s choice of accounting policies.

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In analyzing disclosures related to the financing liabilities of a company, which of the following disclosures would be least helpful to the analyst?

A) The interest expense for the period as provided on the income statement or in a footnote.

B) Filings with the Securities and Exchange Commission (SEC) that disclose all outstanding securities and their features.

C) The present value of the future bond payments discounted at the coupon rate of the bonds.

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When analyzing disclosures related to financing liabilities, analysts would review the balance sheet and find the present value of the promised future liability payments. These payments would then be discounted at the rate in effect at issuance (i.e., the yield to maturity), not the coupon rate of the bonds.