Debt or Equity? The Determinants and Consequences of Accounting Classification of Hybrid Financial Instruments by Dr Zoltán Novotny-Farkas

We examine whether the accounting classification of financial instruments with characteristics of both equity and liability, i.e., hybrid financial instruments, matters for users of financial statements. We predict and find that credit rating incentives are positively associated with the issuance of corporate hybrid bonds (CHBs), while reporting incentives are positively associated with the accounting classification of these CHBs as equity. Equity investors price all CHBs as debt-like instruments around their offerings, when information on their debt-like contractual features is prevalent. However, when presented in financial statements, investors fixate on CHBs’ accounting classification, especially for firms that do not present their CHBs separately in financial statements. We also show that the issuance of equity-labelled CHBs is associated with lower forecast accuracy of analysts when accounting transparency is low. Lastly, results from an event study suggest that investors perceive a potential reclassification of CHBs from equity to debt as costly.