Beatty, Liao, and Weber (2012) investigated delegated monitoring of public debt issues, under which holders of public debt delegate monitoring of the borrower’s financial performance to a specialist, such as a bank. This tactic is common, particularly when a firm has several classes of debt outstanding. When there are several debt classes, holders of a class may leave it to holders of another class to monitor financial performance. If all debtholders feel this way, insufficient monitoring will be carried out. Alternatively, if holders of all debt classes do their own monitoring, total monitoring costs will be high. By hiring a monitoring specialist, these problems are reduced. Knowing that its debt holders may delegate monitoring, the firm may include a cross acceleration covenant in its debt contracts. This is to overcome a problem that arises with multiple debt classes when some classes have greater security than others. For exam-ple, one class may have higher priority to receive debt repayments than another should the firm go into liquidation. Consequently, if the firm enters financial distress, the debt holders with priority may force liquidation even though the firm has a higher expected value if it continues operating. Cross acceleration relieves this problem because all debt classes are treated equally should debt repayments be accelerated because the firm has entered financial distress.
While, cross acceleration may treat all classes of debt equally, another problem remains-namely, inappropriate liquidation. To see why, note that most delegated monitors are banks, and it is likely that the bank has also loaned money to the firm in question. If so, and if the firm approaches financial distress, the bank may trigger liquidation to protect its own position, even though the firm’s value as a going concern exceeds its liquidating value. This is of particular concern to debt holders if their debt is longer- term than the firm’s bank debt.
Consequently, the firm faces a cost– benefit tradeoff when considering inclusion of a cross acceleration covenant in its debt contracts. Its borrowing costs will be reduced to the extent that debt investors feel more secure because of cross acceleration, but will be increased to the extent that investors are concerned about inappropriate liquidation.
Delegated monitoring and cross acceleration are of interest to accounting since, as mentioned, most delegated monitors are banks, which have usually loaned money to the borrowing firm. As the authors pointed out, bank lending agreements usually contain accounting- based covenants, and the bank will base a decision to demand accelerated repayment, with resulting likelihood of forced liquidation, on these.
BLW studied 1,670 public debt issues from 515 firms over the period 1994– 2007. They reported that 62% of their sample contained cross acceleration provisions. In their study of these contracts, the authors reported several findings, including the following:
i. Cross acceleration is less likely to the extent that the expected going concern value of the borrowing firm exceeds its expected liquidation value. The authors measured expected going concern value by the market value of total assets. They measured expected liquidation value by a proportion of the value of accounts receivable, inventory; property, plant and equipment; and cash.
ii. Cross acceleration is more likely as the number of covenants in the bank’s lending contract increases.
iii. Cross acceleration is more likely as information asymmetry between the firm and investors increases. Information asymmetry is based on the discretionary accrual models of Dechow and Dichev (2002) (Section 5.4.1) and Jones (1991) Section 11.3), with higher discretionary accruals implying lower earnings quality.
iv. The authors also found that interest rates paid by firms with a cross acceleration covenant in their lending agreements are higher on average the grater the level of discretionary accruals.

Explain the likely reasons for each of the findings reported above.

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