Debt Covenants and Financial Reporting Standards}

Debtholders receive note contracts, one for each note, that describe the payments promised by the issuer of the debt. In addition, the issuing corporation frequently enters into a supplementary agreement, called a note indenture, with a trustee who represents the debt holders. The provisions or covenants of the indenture may place restrictions on the issuer for the benefit of the debtholders. For example, an indenture may require that the issuer's ratio of total liabilities to total shareholders' equity never rise above a specified level or that periodic payments be made to the trustee, who administers a "sinking fund" to provide for the retirement of debt.

Consider Roswell Manufacturing's debt indenture, which requires Roswell's ratio of total liabilities to total shareholders' equity never to exceed \(2: 1\). If Roswell violates this requirement, the debt indenture specifies very costly penalties, and if the violation continues, the entire debt issue must be retired at a disadvantageous price and refinanced. In recent years, Roswell's ratio has averaged about 1.5:1 ( \(\$ 15\) million in total liabilities and \(\$ 10\) million in total shareholders' equity). However, Roswell has an opportunity to purchase one of its major competitors, Ashland Products. The acquisition will require \(\$ 4.5\) million in additional liabilities, but it will double Roswell's net income. Roswell does not believe that a share issue is feasible in the current environment. A new accounting standard requires accounting for post-employment benefits. Implementation of the new standard will add about \(\$ 2\) million to Roswell's long-term liabilities. Roswell's CEO, Martha Cooper, has written a strong letter of objection to the accounting standard-setting organization, which has received similar letters from over 300 companies.

\section*{Required:}

1. Write a paragraph presenting an analysis of the impact of the new standard on Roswell Manufacturing.

2. If you were a member of the accounting-standard-setting organization and met Martha Cooper at a professional meeting, how would you respond to her objection?

\section*{Case