Closing Loopholes in the Accounting of Convertible Debt and the Impact of Call Features

33 Pages Posted: 5 Jul 2010

See all articles by Craig M. Lewis

Craig M. Lewis

Vanderbilt University - Finance

Patrick Verwijmeren

Erasmus University Rotterdam (EUR)

Date Written: July 4, 2010

Abstract

Cash settlements became a popular design feature in convertible securities once they obtained favorable accounting treatment for diluted earnings per share in 2002. The unexpected proliferation of cash settlements provoked the FASB to eliminate their favorable accounting treatment in 2008. We find that shareholders of firms that use cash-settled convertibles react negatively to the announcement of these changes. Firms that issued cash-settled convertible debt to avoid earnings dilution no longer have an incentive to keep them on their balance sheets. Consistent with this observation, we find that investors respond more favorably if the cash-settled convertibles of these firms include call features. We conclude that call features can be valuable in times of accounting changes as they allow the firm to mitigate the effects of the accounting changes on their financial reporting. Our results therefore provide an accounting-based motivation for incorporating call features into securities.

Keywords: Convertible securities, cash settlements, APB 14-1, call features, earnings management, economic consequences of accounting changes

JEL Classification: G32, M41

Suggested Citation

Lewis, Craig M. and Verwijmeren, Patrick, Closing Loopholes in the Accounting of Convertible Debt and the Impact of Call Features (July 4, 2010). Available at SSRN: https://ssrn.com/abstract=1634681 or http://dx.doi.org/10.2139/ssrn.1634681

Craig M. Lewis

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States

Patrick Verwijmeren (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

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