Beatty, Weber, and Yu (2008) analyzed a sample of U. S. firms with debt covenants that required the firm to maintain a specified level of net worth. Almost two-thirds of these covenants contained income escalators, whereby the required level of net worth to be maintained increased by a specified percentage (e. g., 50%) of positive net income. If net income was negative, the required level did not decrease. The authors’ findings included the following:

Firms with high information asymmetry between the firm and its lenders (i. e., high estimation risk) were more likely to include income escalator clauses in their net worth covenants. The higher the information asymmetry, the greater are lenders’ concerns that firm managers may behave opportunistically by, for example, paying excessive dividends and/ or managing earnings upward to cover up or delay solvency concerns. Lender concerns can be measured by the spread between bid and ask price when bonds are traded (a higher spread suggests greater lender concerns), by the firm’s credit rating, and by the magnitude of its accruals (high accruals suggest a volatile operating environment, which can lead to increased probability of covenant violation). All of these concerns increase with information asymmetry.

Income escalator clauses and conservative accounting (including both conditional and unconditional conservatism) were positively associated. That is, firms with income escalator clauses in their net worth covenants were more likely to adopt conservative accounting policies. This finding was after allowing for other reasons for conservative accounting such as investor demand and concern about litigation. This finding is of interest because it implies that conservative accounting alone is not sufficient for efficient debt contracting. Rather, a combination of conservative accounting and sophisticated debt covenants may further increase contracting efficiency.

Required

a. Why do debt contracts often contain covenants requiring maintenance of a specified level of net worth?

b. Managers of firms with higher information asymmetry between the firm and its lenders have greater opportunities to opportunistically manage earnings upward. Why would such firms include income escalator clauses in their debt covenants?

c. Explain why income escalator clauses and conservative accounting work together to benefit investors. Give two examples of conservative accounting policies in your answer.