Friedman’s Inc. is a leading fine jewelry retailer. In November 2004, the company said that it might default on certain of the financial covenants contained in one of the company loan agreements. Here is an excerpt from the company’s press release: In particular, Friedman’s expects that it will fail to meet cumulative EBITDA requirements for the period ending October 30, 2004, constituting a default under its term loan, and it will fail to meet a minimum ratio of Accounts Payable to Inventory as of October 30, 2004, constituting a default under both its term loan and its revolving loan. Friedman’s is currently in discussions with its senior lenders under the credit facility regarding the amendment of its covenants to eliminate the default.

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Apparently, Friedman’s term loan contained a provision that required the company to maintain a minimum level of profitability (measured using EBITDA) over several periods (hence, the use of “cumulative,” meaning summed over the periods in question).

Required:

1. What will happen to the company if it violates these two covenants and is unsuccessful in obtaining a waiver or amendment from senior lenders?

2. Explain how the EBITDA covenant creates an incentive for Friedman’s to engage in aggressive accounting practices. Provide one or more examples of aggressive accounting that Friedman’s might use to avoid violating the EBITDA covenant.

3. Explain how the accounts payable to inventory covenant also creates an incentive for Friedman’s to engage in aggressive accounting practices.