In an article that appeared in The Australian on 28 July 2014 entitled ‘Southern Cross CFO quit over writedown’ (by Darren Davidson) it was reported that: Mr Lewis joined Southern Cross after it issued a profit downgrade in May. The owner of the 2DayFM radio network said that it expected full-year net profit to fall 10 per cent below the previous year’s underlying NPAT of $89 million. Although the company’s gearing remains within its banking covenant of less than 3.5 times earnings before interest, taxes, depreciation and amortisation, there is concern in the market the company is slipping into a danger zone with its debt covenants. Some market analysts believe that if revenues continue to deteriorate, gearing of above three times EBITDA could trigger a breach of banking covenants.

REQUIRED

A. Why might the debt covenants have originally been agreed to by Southern Cross?

B. Why would a reduction in earnings potentially affect the debt covenants?

C. In general, and according to the ‘debt hypothesis’ often utilised within Positive Accounting Theory, if an entity is close to breaching accounting-based debt covenants then what action might the entity take?