Q1. 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)   both are incorrect.

B)   only one is correct.

C)   both are correct.

Q2. 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)   Bond covenants are important in valuing a firm’s equity including its growth prospects.

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

答案和详解如下：

Q1. 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)   both are incorrect.

B)   only one is correct.

C)   both are correct.

Correct answer is B)         

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.

Q2. 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)   Bond covenants are important in valuing a firm’s equity including its growth prospects.

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

Correct answer is C)

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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