Why would managers agree to enter into lending agreements that incorporate covenants? - Lenders expect to be compensated for risk. Debt covenants reduce the risk to the lender and thus result in lower interest costs being imposed on the borrower. As a result of agreeing to debt covenants, managers may also be able to borrow more funds and/or for longer periods.
How does accounting information reduce agency problems in relationships between management and shareholders? - Accounting information is used in contracts that are designed to reduce agency problems in the relationship between shareholders and management. Accounting numbers are used to specify targets, monitor performance and determine rewards. For example, a bonus might be calculated as 1% of profit, provided return on equity exceeds 7%. Thus, the accounting information is used to specify the target (e.g., return of equity greater than 7%). Reported accounting numbers are used to measure performance against the target to determine eligibility for a bonus (e.g., whether the hurdle of 7% return on equity has been exceeded) and to determine the amount of the bonus, if any, payable to the manager (e.g., 1% of reported profit).
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