Does Balance Sheet Classification Matter? Evidence from Trust Preferred Stock

Abstract

The Financial Accounting Standards Board (FASB) continues to debate the accounting for financial instruments and the distinction between liabilities and equity. A trend toward shifting items to the liability category is ongoing; for example in 2003 FASB Statement No. 150 required several items, including mandatorily redeemable shares, to be re-classified as liabilities. The AAA Financial Accounting Standards Committee (2001) voiced its concern over the increasing heterogeneity of the liability category and called for quasi-equity categories to improve the representational faithfulness of individual categories. We address the question of whether financial statement categorization of trust preferred stock (TPS) influences its market valuation. We exploit FASB Statement No. 150 as an opportunity for quasi-experimentation. Statement No. 150 required TPS, a mandatorily redeemable financial instrument, to be re-classified from the mezzanine to the liability section of the balance sheet. We empirically test whether the balance sheet label affects market valuation of TPS. Using a sample of 105 firm-year observations from 2001-2004, we find that when TPS is re-classified as a liability the market values TPS more like a liability than when it was reported in the mezzanine. Our evidence adds support to the AAA Committee's contention that financial statement users depend on balances sheet categories, and that additional heterogeneity in the liability section may lead to confusion and miss-interpretation.