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Steve Bartoletti

Loan covenant violations

Posted By: Steve Bartoletti on 11/30/2015 6:54:44 PM, 0 Comments, 22920 views

An auditor wrote to me concerned about a loan that he was auditing that is in violation of the working capital & current ratio covenants. He understood from the recent RMA Journal article that when CPFA is included among current assets, the company is not illiquid. But the covenant is based on the traditional formula—i.e., the company is in “technical” violation. So what is he to do? 

Excellent question! My first thought is “do no harm.” Taking disciplinary action is unfair to the client. The issue is not the liquidity of the borrower, but the definition of liquidity. The proper thing to do is to modify the loan agreement to correct the formula to include CPFA (or depreciation expense as a surrogate) among current assets. Unfortunately, that action would probably be in violation of the lending institution’s written policy which relies on the old formulas.  

Still, I say, “do no harm.” Disciplinary action is bad not only for the borrower, but also for the lender because it is penalizing a good client. If all else is OK (as this auditor so indicated), I would note it as a minor violation and waive it. Then send the case up to the credit policy board along with the RMA Journal article. It may take several such cases to demonstrate the need for changing the policy. The clients most affected are those heavily invested in fixed assets (like AT&T in the article).  

Actually the best action is to change the covenant to a minimum “Trading Capital” which is explained in the Journal of Accountancy article available on this website. (I am about to submit a follow-up article to the RMA Journal which adds this layer of liquidity analysis.)

Finally, I would be glad to be of further service. I welcome the opportunity to meet with senior management of any bank/leasing company to discuss how the discovery of CPFA affects the calculation and covenanting of liquidity. 

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