The Impact of Changes in Accounting Principles on Restrictive Covenants in Credit Agreements and Indentures
The typical institutional or public debt agreement contains numerous financial covenants designed to protect the loan and assure repayment. An institutional loan agreement may require the borrower to maintain a specified excess of current assets over current liabilities, a specified current ratio and a specified amount of net tangible assets "NTA" In addition, the borrower may be prohibited from incurring (or permitting to have outstanding) current or funded indebtedness in excess of a specified percentage of NTA. The borrower may also be prohibited from incurring lease liabilities in excess of a specified percentage of NTA and may be permitted to pay dividends or repurchase its securities only out of net income earned subsequent to a "peg" date (usually the end of the fiscal year immediately preceding the date of the loan) plus an agreed amount. A typical public debt issue will have a dividend restriction tied to net income and may have a senior debt restriction tied to NTA as well as a secured debt and sale and lease back provision tied to NTA. NTA, net income, current assets and current and funded indebtedness are normally defined with reference to generally accepted accounting principles "GAAP".1 As a result of several significant developments during the last few years and the likelihood of continued major changes, the effect of a change in an accounting principle on the definitions of accounting terms and