Tested on reported numbers, so reporting choices matter

What a covenant is

When Tamarack borrowed its $1.2 million of term debt, the bank did not simply hand over the money and wait. The loan agreement contains covenants — promises the borrower makes for the life of the loan. Some are negative covenants (no further borrowing above a stated amount, no dividends above a stated fraction of income, no sale of major assets without consent). The ones this lesson tests are financial covenants: ratio ceilings and floors, measured on the audited financial statements every year-end. Tamarack’s agreement says:

Debt-to-equity        ≤ 0.90
Current ratio         ≥ 1.50
Times interest earned ≥ 4.0

The lender imposes them because the loan ranks ahead of the shareholders but has no upside: the bank earns 80 of interest whether Tamarack has a great year or a terrible one, so its only concern is that the company stays solvent enough to repay. The covenants are an early-warning system, and — this is the point of the lesson — they are tested on reported numbers. Whatever moves the reported figures moves the test.

Testing 2025

Debt-to-equity        1,800 ÷ 2,200 = 0.818   ≤ 0.90  ✓
Current ratio         1,600 ÷ 700   = 2.286   ≥ 1.50  ✓
Times interest earned   720 ÷ 80    = 9.0     ≥ 4.0   ✓

Comfortable on all three. Now suppose the auditors, applying LCNRV (Module 2), require a $300 thousand write-down of a line of tents that a competitor has just undercut. The write-down is charged to cost of goods sold, so (ignoring the tax effect) EBIT falls from 720 to 420; net income and therefore equity fall by 300, to 1,900; inventory and current assets fall by 300, to 1,300. Liabilities do not move.

Debt-to-equity        1,800 ÷ 1,900 = 0.947   ≤ 0.90  ✗ BREACH
Current ratio         1,300 ÷ 700   = 1.857   ≥ 1.50  ✓
Times interest earned   420 ÷ 80    = 5.25    ≥ 4.0   ✓

One accounting entry — required by the standard, involving no cash — has put the company in breach of its loan agreement. Debt-to-equity is the most sensitive of the three because the write-down hits its denominator with nothing to offset it.

What happens on a breach

A breach is technically an event of default: most agreements let the lender demand immediate repayment of the whole balance, which also reclassifies the debt as current on the balance sheet and can trip the current-ratio covenant in turn. In practice a lender with an otherwise sound borrower usually grants a waiver for the period, or the two parties renegotiate — a higher interest rate, extra security, a tighter dividend restriction, a fee. The company that hides a breach until the audit is the one that gets the demand letter; the one that phones the bank in advance with a plan usually gets the waiver.

Errors count too

An inventory error (Module 2) is a mistake rather than a policy, but the lender sees the year-1 statements as issued. Suppose Tamarack had overstated closing inventory by 150 through a double count. Reported equity and current assets are each 150 too high, and EBIT is 150 too high; the correct figures are equity 2,050, current assets 1,450, EBIT 570 — debt-to-equity 0.878, current ratio 2.07, TIE 7.1, all still compliant. Had the overstatement been 400 instead, correcting it would have taken debt-to-equity to 1.00 — and a covenant that appeared satisfied on the issued statements would have been breached on the true ones. The error self-corrects in year 2; the loan agreement does not.

That is why this course keeps returning to “reporting choices matter”: the frameworks, estimates and entries of the midterm half are not academic. A write-down, a depreciation estimate, an impairment test or a cut-off error each changes a number a lender is measuring.