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368 W. Moser et al.
1 3
sources (TPS/External Capital), and greater access to investment-grade public debt
(Non-Investment Grade).
6.3 Multivariate analyses
We report three specications of our logistic regression in Table 4. Models 1 and 2
include Affected Covenants and OI-Retire Debt as separate terms, respectively. In
Model 3, we include both terms to test for incremental effects. Model 1 has a pseudo
R
2
of 19.10% and a correct prediction rate of 78.3%, while model 2 has a pseudo R
2
of 12.90% and a correct prediction rate of 73.7%. The greater explanatory power of
model 1 suggests that Affected Covenants is a stronger predictor of rms redeem
versus reclassify choices. Model 3, which includes both Affected Covenants and
OI-Retire Debt, has the highest explanatory power with a pseudo R
2
of 23.0% and a
correct prediction rate of 80.8%.
When included separately, the coefcients on Affected Covenants (1.949,
t-statistic = 2.61) and OI-Retire Debt (1.299, t statistic = 1.85) are positive and
Table 4 Logistic regressions
Model 1 Model 2 Model 3
Variables
Intercept -4.178* (1.89) -3.777* (1.66) -4.228* (1.89)
Affected covenants 1.949*** (2.61) 1.774** (2.29)
OI-retire debt 1.299* (1.85) 0.967 (1.26)
LnMVE 0.482* (1.67) 0.434* (1.68) 0.484* (1.66)
Market-to-book 0.116 (0.97) 0.103 (0.83) 0.128 (1.05)
ROA -9.599* (1.94) -8.071* (1.82) -9.514* (1.92)
Debt ratio -0.595 (0.25) -2.121 (1.03) -1.296 (0.54)
TPS/external capital 7.148* (1.69) 4.745 (1.53) 6.398 (1.60)
Non-investment grade 0.904 (1.08) 1.041 (1.35) 1.141 (0.19)
Observations 58 58 58
Pseudo R
2
19.10% 12.90% 23.00%
Correction prediction (%) 78.30% 73.70% 80.80%
Elasticity estimate 26.88% 22.35% n.a.
This table presents logistic regressions for the determinants of the choice to redeem (versus reclassify)
trust preferred stock after FAS 150. The sample consists of 58 industrial rms, 36 of which chose to
redeem. The dependent variable, Redeem, is a binomial variable coded 1 if the rm chose to redeem its
trust preferred stock in the 2003 through 2005 period following the enactment of FAS 150 and 0
otherwise. Affected Covenants, OI-Retire Debt, MVE, Market-to-Book, ROA, Debt Ratio, TPS/External
Capital, and Non-Investment Grade are dened in Table 1. Elasticity Estimates for Affected Covenants
(in model 1) are computed as the difference in probability of having Affected Covenants, estimated using
models with Affected Covenants = 0 versus Affected Covenants = 1 while holding other variables at the
mean values. Elasticity Estimates for OI-Retire Debt (in model 2) are computed as the difference in
probability of having OI-Retire Debt, estimated using models with OI-Retire Debt = 0 versus OI-Retire
Debt = 1 while holding other variables at the mean values. T statistics are in parentheses below each
coefcient estimate
***, **, and * denotes signicance at the 1, 5, and 10% level, respectively
Bank debt covenants and rms responses to FAS 150 liability recognition 369
1 3
signicant. We estimate the elasticity of each variable and nd that the probability
of redeeming TPS increases by 26.88% for rms with Affected Covenants and by
22.35% for rms that used the original TPS proceeds to retire debt (OI-Retire Debt).
In the combined estimation (model 3), only Affected Covenants is signicant. Our
regression results are consistent with both hypotheses 1 and 2 and with Affected
Covenants providing the dominant effect.
The results for the control variables provide some evidence that the probability of
redeeming TPS declines with protability (ROA) and increases with the magnitude
of TPS as a proportion of external funding sources (TPS/External Capital). After
controlling for these effects, there is also a positive relation between rm size
(LnMVE) and the probability of redeeming TPS.
Overall, our results provide evidence of the importance of balance sheet
classications for rms with binding debt contracts and their willingness to make
substantive capital structure changes in response to the new reporting requirements
of FAS 150.
6.4 Supplemental test variable specication
We supplement our multivariate analysis using a coarser measure of bank debt
covenants: Financial Covenants. Financial Covenants is a binomial variable coded
as 1 for rms with bank debt covenants that include debt or interest in their
calculation and 0 otherwise. In contrast to Affected Covenants, this variable makes
no attempt to distinguish between oating or xed GAAP as the basis for
dening the debt or interest terms. In effect, this alternative specication provides
evidence on the importance of identifying the specic contractual terms in our tests
of a relationship between debt covenants and TPS redemption decisions.
We report our logistic regression analysis using Financial Covenants as the test
variable in Table 5. The coefcient on Financial Covenants (0.809, t statis-
tic = 1.17) is positive but insignicant. Consistent with Beatty et al. (2002) and
Fields et al. (2001), we conclude that actual debt covenants yield more powerful
tests than proxies.
6.5 Method of redemption
To better understand our rms redemption choices and their underlying incentives,
we also report supplemental data on the method of redemption in Table 6.
Specically, we examine the 10-K ling disclosures of the 36 redeeming rms to
conrm the method and dollar value of their redemptions. Based on these
disclosures and corroborating cash ow statement data, we partition the source of
the redemption funds into four categories: issue/convert to common stock, cash ow
from operations, issue new debt, and multiple sources.
The method of redemption is explicitly stated in the footnotes to the nancial
statements for the 18 rms that nanced their TPS redemptions by issuing new
common stock or exercising TPS conversion features. We estimate that these
redemptions (totaling $7.083 billion) resulted in the forfeiture of more than $495
370 W. Moser et al.
1 3
Table 5 Supplemental logistic regression using Financial Covenants
Model 1
Variables
Intercept -4.047* (1.75)
Financial covenants 0.809 (1.17)
LnMVE 0.447* (1.79)
Market-to-book 0.097 (0.81)
ROA -7.978* (1.83)
Debt ratio -1.725 (0.81)
TPS/external capital 5.276 (1.54)
Non-investment grade 0.737 (1.00)
Observations 58
Pseudo R
2
9.55%
Correction prediction (%) 72.60%
This table presents logistic regressions for the determinants of the choice to redeem (versus reclassify)
trust preferred stock after FAS 150. The sample consists of 58 industrial rms, 36 of which chose to
redeem. The dependent variable, Redeem, is a binomial variable coded 1 if the rm chose to redeem its
trust preferred stock in the 2003 through 2005 period following the enactment of FAS 150 versus
reclassifying the TPS as a debt liability and 0 otherwise. Financial Covenants is a dummy variable coded
as 1 if a rm has bank debt covenants that include debt or interest in their terms. In contrast to Affected
Covenants, Financial Covenants makes no attempt to distinguish covenant terms that are actually affected
by FAS 150 due to the use of oating GAAP. MVE, Market-to-Book, ROA, Debt Ratio, TPS/External
Capital, and Non-Investment Grade are dened in Table 1. T statistics are in parentheses below each
coefcient estimate
***, **, and * denotes signicance at the 1, 5, and 10% level, respectively
Table 6 Redemption method
Number $ Million
redemption
Number where
OI-retire debt
$ Million where
OI-retire debt
Issue/convert to common stock 18 7,083 9 5,023
Cash ow from operations 10 5,452 6 3,873
Issue new debt 1 265 0 0
Multiple sources 7 2,002 4 1,414
Total redemptions 36 14,802 19 10,310
The table reports summary statistics on the method of redemption for 36 industrial rms that redeemed
their trust preferred stock following the enactment of FAS 150 during the 2003 through 2005 period. We
partition redemptions into four categories based on the source of funds used to redeem trust preferred
stock. The categories are (1) issue/convert to common stock, (2) cash ow from operations, (3) issue new
debt, and (4) multiple sources. For each category we report the number of TPS redemptions and the
corresponding dollar amount (in millions) of trust preferred stock redeemed. We also report statistics for a
subcategory of redeeming rms that used the proceeds of the original trust preferred stock issue to retire
existing debt (OI-Retire Debt)
Bank debt covenants and rms responses to FAS 150 liability recognition 371
1 3
million in annual interest deductions with a potential tax cost of $173 million.
20
For
the remaining 18 redeeming rms (id est, those that did not redeem using only
common stock), we use data from the cash ow statements to determine available
funding sources. It appears that only one of these rms would be required to issue
new debt to nance its TPS redemption. This is consistent with rms minimizing the
consequences of liability recognition rather than simply replacing a less attractive
security with other sources of lower cost debt.
Our nding that some rms chose to redeem their TPS rather than renegotiate with
lenders suggests that these rms either could not amend their debt contracts or faced
higher relative renegotiation costs. Prior research suggests that the cost of negotiating
exibility in debt contracts can be large. Beatty et al. (2002) nd evidence that rms
pay substantially higher interest rates to retain accounting exibility that may help
them avoid covenant violations. Recent studies in nancial economics (for example,
Roberts and Su2009) further cite amendment fees, the bargaining power of borrowers
to switch lenders, costs incurred in the form of time and effort, and macroeconomic
uctuations in credit and equity markets as signicant factors that affect renegotiation
costs.
21
Overall, our results suggest that rms adversely affected by FAS 150 liability
recognition incurred signicant costs to mitigate the effects on their debt contracts.
7 Conclusions
The passage of FAS 150 in 2003 provides a natural experiment to investigate the
relation between debt contracting and nancial reporting choices. FAS 150
mandated that certain securities (for example, trust preferred stock) be reclassied
from mezzanine nancing to debt liabilities. Although rms have economic
incentives to avoid covenant violations (Watts and Zimmerman 1986, 1990),
empirical evidence is largely inconclusive on the relation between nancial
covenants and accounting choice. We contribute to this literature by examining the
relation between nancial covenant restrictions and rms choice to redeem or
reclassify their outstanding TPS following the enactment of FAS 150.
Our ndings suggest that bank debt covenants signicantly affect rms
economic responses to a mandated accounting change. For rms with bank debt
covenants that are adversely affected by the mandatory accounting change, we nd
a 26.88% increase in the probability that the rm will redeem its TPS. We also
provide evidence that a rms original use of TPS proceeds affects its redemption
decisions in the post-FAS 150 period. Specically, rms that issued TPS to retire
outstanding debt are 22.35% more likely to redeem their outstanding TPS.
20
This calculation is in the spirit of Engel et al. (1999) who use estimated tax savings as a gauge of the
benets from issuing TPS to retire traditional preferred stock. Similar to Engel et al. (1999), we use 35%
as the marginal tax rate for this purpose.
21
Roberts and Su (2009) nd that renegotiations are highly pro-cyclical and that the terms of the
renegotiation are signicantly more favorable for the borrower during periods of economic expansion.
This nding is particularly relevant for rms in our sample since bank loan renegotiations would have
occurred during or immediately following the 2001 recession (the end of the 2001 recession was not
determined by the National Bureau of Economic Research until July 17, 2003).
372 W. Moser et al.
1 3
Our study makes several contributions to the existing literature. First, our
ndings suggest that when bank debt contracts rely on oating GAAP in their
construction of nancial covenants, changes in the underlying GAAP measures can
signicantly inuence rms economic behavior. Second, our results are consistent
with accounting classications within the balance sheet affecting rms real capital
structure decisions. Finally, we provide support for the importance of current
standard setting debates regarding the denition of a liability.
Acknowledgments We would like to thank Richard Sloan (the editor), two anonymous referees, and
seminar participants at the University of Missouri, Texas A&M, and the 2007 American Accounting
Association annual meeting. This paper was presented at the 2007 American Accounting Association
annual meeting with the title Debt Covenants, Balance Sheet Classication, and the Effects of FAS 150:
Evidence from Trust Preferred Stock.
Appendix A: Financial statement disclosures of trust preferred stock holdings
Textron, Inc.
Note 11. TextronObligated Mandatorily Redeemable Preferred Securities of
Subsidiary Trust Holding Solely Textron Junior Subordinated Debt Securities.
In 1996, a trust sponsored and wholly owned by Textron issued preferred securities
to the public (for $500 million) and shares of its common securities to Textron (for
$15.5 million), the proceeds of which were invested by the trust in $515.5 million
aggregate principal amount of Textrons newly issued 7.92% Junior Subordinated
Deferrable Interest Debentures, due 2045. The debentures are the sole asset of the
trust. The proceeds from the issuance of the debentures were used by Textron for the
repayment of long term borrowings and for general corporate purposes. The amounts
due to the trust under the debentures and the related income statement amounts have
been eliminated in Textrons consolidated nancial statements.
The preferred securities accrue and pay cash distributions quarterly at a rate of
7.92% per annum. Textron has guaranteed, on a subordinated basis, distributions
and other payments due on the preferred securities. The guarantee, when taken
together with Textrons obligations under the debentures and in the indenture
pursuant to which the debentures were issued and Textrons obligations under the
Amended and Restated Declaration of Trust governing the trust, provides a full and
unconditional guarantee of amounts due on the preferred securities. The preferred
securities are mandatorily redeemable upon the maturity of the debentures on March
31, 2045, or earlier to the extent of any redemption by Textron of any debentures.
The redemption price in either such case will be $25 per share plus accrued and
unpaid distributions to the date xed for redemption.
Dillards
6. Guaranteed Preferred Benecial Interests in the Companys Subordinated
Debentures
Bank debt covenants and rms responses to FAS 150 liability recognition 373
1 3
Guaranteed Preferred Benecial Interests in the Companys Subordinated
Debentures are comprised of $200 million liquidation amount of 7.5% Capital
Securities, due August 1, 2038 (the Capital Securities) representing benecial
ownership interest in the assets of Dillards Capital Trust I, a wholly owned
subsidiary of the Company, and $331.6 million liquidation amount of LIBOR plus
1.56% Preferred Securities, due January 29, 2009 (the Preferred Securities) by
Horatio Finance V.O.F, a wholly owned subsidiary of the Company.
Holders of the Capital Securities are entitled to receive cumulative cash
distributions, payable quarterly, at the annual rate of 7.5% of the liquidation amount
of $25 per Capital Security. The subordinated debentures are the sole assets of the
Trust and the Capital Securities are subject to mandatory redemption upon
repayment of the subordinated debentures. Holders of the Preferred Securities are
entitled to receive quarterly dividends at LIBOR plus 1.56%. The Preferred
Securities are subject to mandatory redemption upon repayment of the debentures.
The Companys obligations under the debentures and related agreements, taken
together, provide a full and unconditional guarantee of payments due on the Capital
and Preferred Securities.
Appendix B: Debt covenant denitions in bank lending agreements
United Rentals Inc
Specically Excludes Trust Preferred Stock (QUIPS)
Funded Debt means (a) all Debt of Holdings and its Subsidiaries and (b) to the
extent not included in the denition of Debt, without duplication, all Outstanding
Securitization Obligations, but excluding (1) contingent obligations in respect of
undrawn letters of credit and Suretyship Liabilities (except to the extent constituting
contingent obligations or Suretyship Liabilities in respect of Funded Debt of a
Person other than Holdings or any Subsidiary), (2) Hedging Obligations, (3) Debt of
Holdings to Subsidiaries and Debt of Subsidiaries to Holdings or to other
Subsidiaries and (4) Debt (including guaranties thereof) in respect of the QuIPS
Debentures and the QuIPS Preferred Securities. It is understood that the Tranche B
Credit-Linked Deposits shall not constitute Funded Debt.
Central Parking Corporation
Specically Includes Trust Preferred Stock in Debt
Funded Debt means, with respect to any Person, without duplication, (1) all
Indebtedness of such Person for borrowed money, (2) all purchase Money
Indebtedness of such Person, including without limitation the principal portion of all
obligations of such Person under Capital Leases, (3) all Guaranty Obligations of
such Person with respect to Funded Debt of another Person, (4) the maximum
available amount of all standby letters of credit or acceptances issued or created for
374 W. Moser et al.
1 3
them account of such Person, (5) all Funded Debt of no other Person secured by a
Lien on any Property of such Person, whether or not such Funded Debt has been
assumed, provided that for purposes hereof the amount of such Funded Debt shall be
limited to the greater of (A) the amount of such Funded Debt as to which there is
recourse to such Person and (B) the fair market value of the property which is
subject to the Lien, (6) the principal Balance outstanding under any Synthetic Lease,
and (7) the principal amount of the subordinated notes issued by the Parent to the PS
Subsidiary in connection with the Preferred Stock. The Funded Debt of any Person
shall include the funded Debt of any partnership or joint venture in which such
Person is a general partner or joint venture.
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