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hello! i was just solving a sep/dec 2017 question prancer construction co and in the question it says that “Prancer Construction Co’s prior year financial statements and August 20X7 management accounts contain a material overdraft balance. The finance director has confirmed that there are minimum profit and net assets covenants attached to the overdraft.”, can you please explain what this means? what are minimum profit and net assets covenants and what does them being attached to an overdraft mean?
in the answers (audit risks) there is a risk that “a provision could be understated, especially in light of the overdraft covenant relating to a minimum level of net assets and is being used as a mechanism to manipulate profit and asset levels” how and why are profits being manipulated & how is the covenant related to the manipulation of profits?
thank you
You should know from FA/F3 that a bank overdraft is a facility which a banks offers to a business – say to take from the bank up to $200,000. As well as charging interest on these short-term borrowings (nothing is free), the bank may require some security for making the overdraft available and may stipulate conditions conditions. The business agrees (“covenants”) to meet these conditions. So the bank is effectively saying “you can borrow up to this amount as long …. you make a minimum profit before tax of $50,000 (i.e. the business must have profits in order to pay interest) and net assets (i.e. assets – liabilities) do not fall below $250,000 (i.e. after settling all other liabilities, sufficient assets remain to settle the overdraft).
You can see now that the business would have a reason to “hide” a provision (a liability) and keep it “off the books” to keep net assets above the minimum threshold – because if net assets falls below the minimum, the bank could “call in the overdraft” (which is technically repayable on demand).
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