Debt covenant violations and managers' accounting responses - Assignment Example

Debt-covenant Violation and Managers Accounting Responses al affiliation and number Debt-covenant violation and managers accounting responses, a journal article by Sweeney looks at the accounting changes, costs of default, and accounting-based covenants violated by 130 firms. Sweeney describes how managers achieve their goals of defaulting agreements through net worth and working capital restrictions as set by companies. Sweeney intensely explains the change in accounting procedures, the types of accounting procedures that undergo changes, the appropriate time managers make the changes, the extent to which the alterations affect the restrictiveness of accounting-based covenantsi.

Sweeney keenly points out how managers change accounting procedures as they opt to respond to the tightening debt-covenant constraints. Sweeney explains further on how managers change accounting procedures in order to reflect the magnitude of the earnings effect in cases of tightening debt-covenant constraint. The earnings affect the magnitude of the accounting changes need to relate to the magnitude of the change in the decline in liquidityii. Majority of the losses and dividend reductions by defaulting companies arise in order to refrain itself from the binding covenants.

Indeed, Sweeney affirms that managers change to income-increasing accounting procedures as the company encounters technical default. Sweeney laid down the various types of accounting procedures that undergo changes, in an attempt to ensure execution of contract violation is successful. Sweeney surveys how companies alter the depreciation and ICT methods in order to violate the contractual obligation. However, a default would have little opportunity to increase reported earning via changes in depreciation and ICT method.

Companies violate the accounting procedures that include those of the preparations of the net-worth and working capital documentation. However, debt-equity ratio and income based covenants are least violated as they do not have a lot of influence on the company’s violation of debt-constraint agreement. Even though adjustments will favor the company the charges on the debts will still stand. Sweeney explains that there exists an appropriate time when the managers seek to default the contractual obligation.

Sweeney explains how uniformity in default occurs within a control sample accounts for industry-wide accounting policies. Therefore, firms in the same industry always face similar contracting and financial reporting problems this eventually leads to uniformity in the application of accounting policiesiii. As a result, firms that operate in the same industry tend to change accounting procedures to suit them appropriately at the same time when all the other firms in the industry are set to execute the default.

Indeed, Sweeney concurs to the fact that there is an extent to which the alterations affect the restrictiveness of accounting-based covenants. Sweeney keenly explains that a default is more precise when it leads to difficult situations for companies that have proven not to oblige to its agreement with the lending firm. In addition, firms that tend to default face restrictions in terms of accessing further borrowing that puts them in a bad state as they cannot access credit facilities.

Sweeney explains that when managers change accounting procedures depend on whether the lenders will impose an interest rate on default cost for the company or notiv. In this case, most companies will cautiously avoid default as it would lead them to an extremely worse financial position due to increased interest rates charged on outstanding debt. Indeed, Sweeney explains that managers of the companies that have loans should not default them as it would lead to extreme implications.

Default of the debt-constraint agreement would affect the company’s financial position as it cannot gain access to loan facilitiesv. It is crucial for companies to fulfill its contractual obligation by observing the accounting procedures. Sweeney. A. (1994). Debt-covenant violations and managers’ accounting responses. North Holland. Journals of Accounting and Economics. 17 :281-308.