Instructional Case: Tully Pty Ltd.

Abstract This case demonstrates how a firm's accounting and operating decisions can interact. Tully Pty Ltd's financing policy is directly linked to its accounting policy, because restrictive covenants in its lending agreement are defined in terms of the numbers contained in its financial statements. Students assume the role of a lending officer confronted with a request to change the lending agreement. In developing an argument to support their recommendation, students discover how a proposed accounting standard can affect a firm's compliance with its restrictive covenants and how management's responses to changing economic conditions can be severely constrained by accounting-dominated covenants. In this case, a proposed standard on lease capitalization would place Tully in default. Additionally, Tully's borrowing limitations have "forced" it to alter its financing mix and exposed it to interest-rate volatility. Either could provide the motivation for the proposed amendments to the covenants which, since this is a private agreement, are relatively low-cost to negotiate. In the absence of low-cost renegotiation, students discover that proposed changes in accounting standards can affect existing contracts in such a way as to provide very real incentives to "manage" the accounting numbers.