Companies routinely face debt covenants and occasionally these covenants are binding. That is, the company’s financial statements indicate that the covenant has been violated or is close to being violated. Managers have historically used various means to improve their reported numbers to avoid binding covenants, including adjusting accounting accruals and making “real” operating changes such as decreasing certain discretionary expenses or cutting back on capital expenditures.

a. How do accounting accrual adjustments affect covenants that require minimums for retained earnings or for certain ratios such as the current ratio? Are those effects permanent?

b. How do real operating changes affect covenants that require minimums for retained earnings or for certain ratios such as the current ratio? Are those effects permanent?

c. What consequences might arise if the company focuses on managing reported numbers to avoid violating debt covenants? What parties are affected by such schemes?