The Debt/Equity Distinction and the Classification of Convertible Financial Instruments

Abstract

In this thesis I examine three issues surrounding the classification of convertible financial instruments. The research examines the classification prior to the adoption of NZ IAS 32 which mandates the presentation of convertibles in the financial statements of the issuer. Pending the introduction of NZ IAS 32 it was common for issuers to choose to classify convertibles in one of equity, other capital funds or debt. The first issue I investigate is the factors that may influence the classification of convertibles in the financial statements of the issuer. Theory suggests that leverage related variables are likely to influence the classification but my research indicates that these variables are not related to the classification adopted. However, the contractual conversion terms are found to be related to the classification adopted. The second issue investigated is the value relevance of the financial statement classification chosen by issuers. I find that classification as debt or as equity is value relevant but classification as other capital is not value relevant. Finally I restate the convertibles in the sample to comply with NZ IAS 32. On average the economic impact of this is a reduction in the number of companies that meet ratios commonly used in debt covenants and a decrease in the Z score calculated using financial distress models. I also find that the restated amounts are value relevant.