Capital restructuring in response to mandatory accounting changes : evidence of debt contract effects.

Abstract

Traditionally, one motivation behind United States (US) firms issuing mandatorily redeemable preferred stock (MRPS) is the supply of quasi-debt whilst keeping debt off the balance sheet. Statement of Financial Accounting Standard No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150), however, now requires MRPS to be classified as a liability in the issuer's balance sheet. Consistent with this classification, dividends to MRPS holders must be classified as interest expense in the income statement. The resultant increase in debt and interest expense when US firms adopt SFAS 150 increases their likelihood of debt covenant violation (Mulford and Maloney, 2003; Rapoport and Weil, 2003; McCarthy Schneider and Seese, 2004; Reinstein, 2004; Schroeder, Sevin and Schauer, 2006). The purpose of this study is to examine whether firms, in response to SFAS 150, restructure their MRPS to avoid debt covenant violation. MRPS restructuring is defined to occur when firms: (1) retire MRPS before the fixed redemption date, thereby removing the stock from the balance sheet; (2) remove the fixed redemption date; or (3) introduce a conversion feature. Either of these two latter approaches introduces preferred stock attributes that enable liability classification to be averted (Kirchner, 2003; Sinnett, 2003). This thesis addresses two research questions: (1) Do firms engage in MRPS restructuring following the introduction of SFAS ISO?; and, if so (2) Do firms engage in MRPS restructuring as a function of their private debt contract characteristics? The first research question examines whether firms reduce their reliance on MRPS financing (by engaging in MRPS restructuring) following the financial reporting requirements promulgated in SF AS 150. The second research question leads to hypotheses predicting associations between MRPS restructuring and private debt contract characteristics that influence a borrower's perception of the relative cost-effectiveness of MRPS restructuring in avoiding debt covenant violation. Inter alia, variation in the cost¬effectiveness of MRPS restructuring as a violation avoidance technique is attributable to the characteristics of the debt contract. Debt contract features (namely, the type, specificity, and stringency of the debt covenants) determine whether violation will occur upon adopting SFAS 150 and, consequently, whether violation costs will be incurred. Moreover, the costs of renegotiating the debt contract to alleviate the covenant violatiun, and the likely costs imposed upon violation, influence the viability of MRPS restructuring as a response to SFAS 150 reporting requirements. The study finds that firms reduce their reliance on MRPS financing when debt classification is mandated. This result supports the assertion that firms have traditionally issued MRPS to obtain off-balance sheet debt financing and, upon its elimination, managers view MRPS as a less attractive finance source. Reduced reliance on MRPS financing is particularly so for those firms increasingly likely to violate leverage covenant constraints upon adopting SFAS 150. Results also show that the decline in reported MRPS outstanding is negatively associated with firms' financial risk (indicating managers' concerns about the impact the debt classification of MRPS has on credit analyst and investor perceptions), and free cash flows available to satisfy early redemption requirements.