Which type of equity capital would have a delayed diluted effect on a corporation

Traditionally, convertible securities are settled in stock upon conversion. This practice changed almost immediately after the Financial Accounting Standards Board (FASB) clarified the accounting treatment of cash settlement features in convertible debt as it relates to fully diluted earnings per share. Specifically, the FASB amended Emerging Issues Task Force (EITF) 90-19 in January 2002 to allow for the exclusion of potentially cash-settled convertible shares in fully diluted earnings calculations. In response to this ruling, cash-settled offerings became the most popular payment choice. Lewis and Verwijmeren (2011) show that cash settlements represent over 86% of the convertible issues in 2006.

The proliferation of cash settlements prompted the FASB to add a new project to the EITF's agenda in January 2007 to reconsider the appropriateness of the guidance in Issue 90-19. Ultimately, FASB Staff Position (FSP) APB 14-1 was adopted on March 26, 2008 in a decision that effectively nullifies EITF 90-19. The main reason that these changes were made is that most cash settlement features provide the issuer with an option to “pay” investors at least partially, if not completely, with newly issued shares. As a consequence, cash-settled debt is much more like traditional convertible debt, and contingent shares should be reflected as equity on a firm's balance sheet. APB 14-1 prescribes that cash settlement instruments should be divided into debt and equity components. Debt value is calculated using the interest rate that would apply to a similar debt instrument without a conversion option, and the value of the equity component is the residual. The equity component represents the debt discount and will be amortized over interest cost for the estimated life of the security. As a result, the reported interest costs for firms with outstanding cash settlements will increase. We follow the above procedure to calculate the debt discounts and the yearly increase in reported interest for firms with outstanding cash settlements.2 We obtain a sample of 179 firms that issued cash settlements before the 2008 accounting changes and estimate that APB 14-1 will increase the average (median) reported interest costs for these firms by a relative 42.9% (16.0%).

We predict that the changes in accounting standards (mandated by APB 14-1) will be costly to shareholders if the new accounting treatment induces managers to make decisions that they would not have made otherwise. This would be in line with studies showing that changes in accounting rules can have significant economic consequences.3 Our findings on overall wealth effects indicate that shareholders of firms with outstanding cash-settled convertibles indeed react negatively to the accounting changes. We find significant announcement effects on multiple event dates, and estimate that the average cost of the accounting changes is $100 million per firm.

Since the passage of APB 14-1 is specifically designed to curb the use of cash-settled convertible debt as an earnings management device, our cross-sectional empirical predictions mainly deal with earnings manipulation, and the implication of call features.4 We consider whether the different motives used to justify the issue of cash-settled convertibles may affect market reactions. Firms that use these securities for the primary purpose of managing earnings may have delayed calling the bonds to postpone the earnings dilution that occurs when new shares are issued. For these firms, we expect call features to have a marginal positive effect on shareholders' reaction to the accounting changes as an increase in the probability of redeeming in-the-money convertibles transfers wealth from convertible bondholders to shareholders. Moreover, call features are valuable for these firms as they allow the firm to efficiently mitigate the effect of the accounting change.

We base a firm's likelihood of using cash-settled convertibles to boost earnings on three indicators: the specific design of the convertible (certain cash settlement features are more suitable for manipulating earnings than others), whether the firm used a concurrent stock repurchase to reduce outstanding shares on the issue date, and whether the firm had previously issued a Contingent Convertible (CoCo) when these securities had a more favorable accounting treatment that allowed firms to exclude contingent shares from diluted earnings calculations (see Marquardt and Wiedman, 2005).5 We find that abnormal returns are more negative for firms that issue convertible debt for the purpose of managing earnings. Our tests of the interaction between earnings management and call features indicate that investor responses are more favorable for earnings management candidates that issued cash-settled convertibles with call features. This is in line with the prediction that call features are an efficient way of removing cash-settled convertibles from the balance sheet.

Our study highlights the value relevance of the accounting treatment of convertible bonds, and suggests that some firms are likely to have used cash settlements for the primary purpose of managing earnings. Prior studies have highlighted other factors that are important in issuing and designing convertible bonds. Green (1984) argues that convertible debt reduces risk-shifting costs that are caused by conflicts of interest between bondholders and shareholders, because conversion privileges mitigate shareholders' incentives to substitute low-risk projects with riskier projects. Constantinides and Grundy (1989) and Stein (1992) show that firms can prefer convertible issues because of the ability of convertible securities to resolve problems associated with asymmetric information. Brennan and Kraus (1987) and Brennan and Schwartz (1988) argue that an important benefit of convertibles compared to straight debt is the relative insensitivity of their value to the risk of the issuing company. Mayers (1998) highlights the usefulness of convertible bonds when sequential financing is required. More recent studies, including Brown et al. (2012), Choi et al. (2010), De Jong et al. (2013), and Loncarski et al. (2009), highlight the importance of hedge funds as buyers of convertible securities, and argue that convertibles are often designed in ways to make them more attractive to hedge funds, for example by changing their equity-likeness. Our study stresses that convertibles are also often designed to obtain favorable accounting treatment.6

Our focus on cash settlements is important as cash-settled convertibles have become very popular, representing a substantial majority of convertible issues after 2002. Given this popularity, the cash settlement feature in convertible bonds can easily be classified as one of the most popular innovations in convertible security design in the past decade. Following their proliferation, cash settlements have been extensively discussed by accounting boards and in the popular media,7 and a Google search on “cash-settled convertible” returns more than a hundred thousand hits. However, academic research on cash-settled convertibles is scarce. In fact, the only other study that we are aware of to study cash-settled convertibles is Lewis and Verwijmeren (2011). They study cash settlements before the recent accounting changes and conclude that incentives to manage earnings are important drivers of the popularity of cash settlements. Our focus is on shareholder reactions to the change in accounting treatment that eliminates the use of cash-settled convertibles as an earnings management device.

We further contribute to the literature by showing that the implications of call features depend on the different motives used to justify the issue of cash-settled convertibles. As a consequence, our results add to traditional motives for incorporating call features into securities. Examples of traditional motivations are that call features could help a firm avoid financial distress when there is asymmetric information (Stein, 1992) and that they can be used to increase debt capacity when firms require sequential financing (Mayers, 1998). We provide an accounting-based motivation. When investors and issuing firms realize that the status of current accounting standards is tenuous and that managers would prefer another type of financing if new accounting standards eliminate the opportunity to boost reported income, call features are valuable as the inclusion of call features provides the issuer with an option to efficiently remove financing instruments.

The remainder of this paper is organized as follows. Section 2 discusses the relevant accounting treatment of cash settlements and the relevant event dates. Section 3 describes our data set and provides summary statistics. Section 4 presents our empirical tests on the mean and cross-sectional wealth effects. Section 5 concludes.

Accounting for convertibles and rule changes

EITF Issue 90-19 (“Convertible Bonds with Issuer Option to Settle for Cash upon Conversion”) provides guidance regarding securities that can potentially be settled in cash. Before 2002, these securities were presumed to be settled in common stock, and treated like traditional convertible bonds with the if-converted method. The if-converted method accounts for convertible debt as though it has been converted at the beginning of the period (or at time of issuance, if later), and the resulting

Data and summary statistics

We obtain our sample of convertible issues from Securities Data Corporation's New Issues database and download issue prospectuses from the SEC Edgar database to obtain detailed information on cash settlement features. Following Lewis and Verwijmeren (2011), we start downloading the issue prospectuses from the year 2000. We collect a sample containing all convertible bond issues with cash settlement features that were issued before January 29, 2007 (i.e. before Event 1). Following standard

Shareholder wealth effects

In this section we examine whether stock prices react significantly to events relating to the accounting changes for cash settlements. We first examine mean effects, and then examine cross-sectional differences.

Conclusion

This paper examines cash settlements, which have been a popular design feature in convertible securities since the FASB clarified the accounting treatment of fully diluted earnings as it relates to convertible securities in 2002. In 2007, the FASB began to modify the accounting treatment of cash settlements. We find that shareholders of firms with outstanding cash settlements react negatively to these changes, indicating that shareholders perceive the accounting changes to be costly to the firm.

Acknowledgments

This article has benefited from comments by Brian Stevens, Chris Veld, and an anonymous referee.

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