Impact of Mandatory Changes in Convertible Debt Accounting: Evidence from APB 14-1

In this paper, I study the economic consequences of APB 14-1 adopted in 2008, which requires that issuers of cash-settled convertible debt divide the total proceeds from the issuances into liability and equity components ("bifurcation). First, I find that 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). The probability of early repurchase is higher when mandatory accounting changes are included in the calculation of debt covenant compliance. This finding is consistent with the debt contracting hypothesis that APB 14-1 increases the probability of debt covenant violations. Next, I examine whether credit rating agencies evaluate the issuers' accounting information differently after the adoption of APB 14-1. I find that the financial ratios in the post-2008 period, such as interest coverage ratios and leverage ratios, can better explain the issuers' credit ratings than those in the pre-2008 period. These empirical results are consistent with the notion that mandatory changes in financial reporting of cash-settled convertible debt lead to changes in managerial behavior and improve the usefulness of information from financial statements used by the credit market.