How Do Experienced Users Evaluate Hybrid Financial Instruments?

• Published date: 01 December 2016
• Author: LISA KOONCE,SHANA CLOR‐PROELL,BRIAN WHITE
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/1475-679X.12129

DOI: 10.1111/1475-679X.12129

Journal of Accounting Research

Vol. 54 No. 5 December 2016

Printed in U.S.A.

How Do Experienced Users

Evaluate Hybrid Financial

Instruments?

SHANA CLOR-PROELL,

∗LISA KOONCE,

†AND BRIAN WHITE

†

Received 20 July 2015; accepted 30 April 2016

ABSTRACT

Hybrid financial instruments contain features of both liabilities and equity.

Standard setters continue to struggle with “getting the classification right”

for these complex instruments. In this paper, we experimentally test whether

the features of hybrid instruments affect the credit-related judgments of ex-

perienced finance professionals, even when the hybrid instruments are al-

ready classified as liabilities or equity. Our results suggest that getting the

classification right is not of primary importance for these experienced users,

as they largely rely on the underlying features of the instrument to make

their judgments. A second experiment shows that experienced users’ reliance

on features generalizes to several features that often characterize hybrid in-

struments. However, we also find that experienced users vary in their beliefs

about which individual features are most important in distinguishing between

∗Department of Accounting, Neeley School of Business, Texas Christian University;

†Department of Accounting, McCombs School of Business, The University of Texas at Austin.

Accepted by Philip Berger.We thank Zheng Leitter and Ben Van Landuyt for their research

assistance. We thank the Neeley School of Business and the Deloitte Foundation for their gen-

erous financial support, and the Alumni Office at the McCombs School of Business for help

in recruiting participants. We thank Jeremy Bentley, Nicole Cade, Scott Emett, Eric Hirst,

Pat Hopkins, Karim Jamal, Ross Jennings, Steve Kachelmeier, Justin Leiby, Bob Libby, Mark

Nelson, Mark Peecher, Ray Pfeiffer, Chad Proell, Kristi Rennekamp, Mary Stanford, Shankar

Venkataraman, an anonymous reviewer, and workshop participants at the following universi-

ties: Alberta, Cornell, DePaul, Georgia Tech,Illinois, Massachusetts–Amherst, Texas Christian,

and Texas for helpful comments.

Data availability: Contact the authors.

1267

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

1268 S.CLOR-PROELL,L.KOONCE,AND B.WHITE

liabilities and equity. Together, our results highlight the importance of effec-

tive disclosure of hybrid instruments’ features.

JEL codes: G23; M41; M48; M49

Keywords: hybrid financial instruments; accounting classification;

disclosure

1. Introduction

Hybrid financial instruments contain features of both liabilities and equity

(Financial Accounting Standards Board (FASB) [2003, 2007]). For exam-

ple, preferred stock typically has a fixed dividend payment, which is a liabil-

ity feature, but it can also have voting privileges, which is an equity feature.1

Some studies suggest that financial statement users would be best served

by determining the appropriate classification for these instruments (e.g.,

Barth, Landsman, and Rendleman [1998], Barth, Hodder, and Stubben

[2013]); that is, are they liabilities, equity, or some combination of both?

Fewer studies suggest that disclosure of the underlying features of these in-

struments may be central to allowing users to evaluate them (e.g., Kimmel

and Warfield [1995]). In this study, we investigate the extent to which ex-

perienced finance professionals, who are making credit-related judgments

and decisions, rely on the underlying features of a hybrid instrument once

it has been classified as a liability or equity.

Investigating this issue is important for several reasons. First, the use

of financial instruments with features of both liabilities and equity is

widespread. Indeed, the last two decades have witnessed a large increase

in the number and type of hybrid instruments used for financing, such as

convertible debt (e.g., BNP Paribas [2013], Dutordoir et al. [2014], Bol-

ger [2015]), and for compensation (e.g., employee stock options, stock ap-

preciation rights payable in stock). Standard setters have long struggled

with the appropriate accounting for these financial instruments, debating

whether they should get the classification issue “right” or whether disclo-

sure, given a particular classification, is the best solution (Ryan et al. [2001],

Botosan et al. [2006]). Thus, shedding light on whether users rely on clas-

sification and/or disclosure of hybrid instruments’ features provides schol-

arly input to standard setters.

Second, prior research has shown the importance of hybrid instruments’

classification (Hopkins [1996], Shah [1996], Frischmann and Warfield

[1999]), but has not systematically tested whether users differentiate

1Ryan et al. [2001, p. 388] distinguish between hybrid and compound financial instru-

ments. While hybrid instruments have characteristics of liabilities and equity, they do not have

distinct components that are straight debt or common equity. Compound instruments, in con-

trast, consist of multiple components, with at least one being a liability and one being equity.

For ease of exposition in this paper, we refer to all financing instruments that have character-

istics of liabilities and equity as hybrid instruments.