Question: Loan Covenants. A loan covenant is a condition requiring the borrower to comply with the terms of a loan agreement. If the borrower does not act in accordance with the covenants, the loan can be considered in default and the lender has the right to demand payment (usually in full).
Required:
a. Why do banks add covenants to loan agreements?
b. The following is a list of common loan covenants. For each covenant, indicate what the bank is trying to accomplish by requiring it.
(1) Maintain hazard insurance/content insurance.
(2) Maintain key-person life insurance.
(3) Make all payments of taxes/fees/licenses.
(4) Provide financial information on borrower and guarantor.
(5) Maintain a certain level in key financial ratios such as
(a) Minimum quick and current ratios (liquidity).
(b) Minimum return on assets and return on equity (profitability).
(c) Minimum equity and minimum working capital.
(d) Maximum debt to worth (leverage).
(6) Make no change of management or merger without prior approval.
(7) Obtain no more loans without prior approval.
(8) Make no dividends/withdrawals or limited dividend withdrawals.
c. For each item 1-7, indicate where the auditor would be most likely to find evidence of the company's adherence with the covenant.
d. Why is it important for an auditor to review the covenants and review documents related to each item listed in (b)?