We examine the relation between accounting-based debt contracts and the economic response of firms with trust preferred stock (TPS) to mandated liability recognition under Financial Accounting Standard (FAS) 150. Our results show that firms’ financial covenants significantly affect their choice to redeem versus reclassify their outstanding TPS. Specifically, firms with bank debt covenants that would be adversely impacted by recognizing TPS as a debt liability are 26.88% more likely to redeem their TPS after FAS 150. We also find that firms are significantly more likely to redeem versus reclassify their TPS after FAS 150 if they used the original TPS proceeds to retire existing debt (id est, to enhance their balance sheets). Our findings suggest that when bank debt contracts use “floating” Generally Accepted Accounting Principles (GAAP) to construct financial covenant terms, changes in the underlying GAAP measure significantly influence firms’ economic behavior.
Review of Accounting Studies – Springer Journals
Published: Mar 25, 2011
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