Debt reclassification and capital market consequences

We provide initial evidence on the economic consequences of a relatively large, fully disclosed, and apparently purposeful reporting decision: the balance sheet classification of short-term obligations as long-term debt in accordance with Statement of Financial Accounting Standard No. 6. We examine a sample of 1,684 American firm-year observations between the years 1989 and 2000 to determine whether reclassification is associated with debt-ratings and equity values. We find that reclassification increases the likelihood of a subsequent debt-rating downgrade. We also find that market value decreases with increases in the amount reclassified, and that equity value is higher after firms cease reclassifying short-term obligations as long-term debt, compared with other firm-years in the sample. Thus, changes in debt classification are empirically linked in predictable directions to subsequent changes in debt ratings and stock values. Taken together, our results show that debt classification is an important publicly-available indicator that may be useful to capital market participants. We discuss several research extensions including the implications of our findings to European companies that convert to IAS in 2005. © 2006 Blackwell Publishing Ltd.

Duke Scholars

Author William J. Mayew Fuqua School of Business