In addition to specifying payments of principal and interest, borrowing agreements(indentures) can include a variety of other provisions that are important to users of financial statements. These provisions are added to make the debt issues more attractive to prospective lenders. Common provisions include restrictive covenants, collateral, and convertibility. Each of these features is described briefly in this section.
Borrowers may agree to various restrictions on management’s ability to invest, pay dividends, incur additional debt, or take other actions that can affect the firm’s ability to meet its repayment obligations. Such restrictive covenants are often based on accounting measurements of assets, liabilities, and/or income. Violation of these restrictions constitutes technical default on the debt and may allow lenders to increase interest rates or impose other penalties on the borrower.
The existence and the nature of restrictive covenants are an important concern to analysts of financial reports. Restrictions that are based directly on accounting measurements, such as working capital (current assets minus current liabilities) and net worth (total assets minus total liabilities, which we have already described as net assets), can affect the choice of accounting methods in use by the firm.
Debt agreements sometimes require that specific assets of the firm be pledged as security in the event of default by the borrower. These assets are termed collateral. Mortgages on office buildings, plant, and equipment are frequent examples, especially in transportation industries such as airlines, railroads, and trucking companies. On the other hand, lenders are sometimes reluctant to accept as collateral a business asset that has limited resale value or alternative use. In these cases, the lender may require that a sinking fund be established to secure the debt. The sinking fund is segregated cash and/or other liquid temporary investments, usually administered by an independent trustee or financial institution and pledged as collateral to retire a specific bond or note.
An attractive feature to many investors is the right to exchange debt instruments for other securities, usually common stock of the borrowing firm. Convertible bonds give the bondholder the option to exchange bonds for a predetermined number of shares of stock. If the stock price subsequently increases above the value of the bonds, the bondholders will likely convert their holdings to stock. Conversely, if the stock price remains below the value of the debt, the bondholders will continue to collect interest and will receive the bond principal at maturity. Convertible debt is described in more detail in Chapter, “Shareholders’Equity,” which discusses shareholders’equity.