Re-Examine Disclosure versus Recognition: Evidence from Convertible Debt Accounting

Abstract

Using a set of hand-collected data, I study the effects of recognizing liability and equity components separately for cash-settled convertible debt as required by APB 14-1. First, I find that issuers view APB 14-1’s requirement as reducing the benefits of using cash-settled convertible debt. Issuers are more likely to reduce the outstanding amount of cash-settled convertible debt when the increase (decrease) in interest expense (leverage ratio) resulting from the bifurcation process is higher (lower). Second, I find that managers are more likely to make such early repurchases when accounting standard changes are included in the calculation of debt covenant compliance. Last, I find that recognition, as compared to disclosure, of liability and equity components helps credit rating agencies to better evaluate the issuers’ accounting information. More specifically, I find that the financial ratios in the post-2008 period, such as interest coverage ratios, can better explain issuers’ credit ratings than do the ratios in the pre-2008 period. These empirical results are consistent with the view that changes in the financial reporting of cash-settled convertible debt have real effects on managerial behaviour and the usefulness of the information in financial statements used by the credit market.