Real and reporting effects of IFRS induced accounting changes for convertible debt. Adam Esplin Mark R. Huson Christina Mashruwala Heather Wier*

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1 Real and reporting effects of IFRS induced accounting changes for convertible debt Adam Esplin Mark R. Huson Christina Mashruwala Heather Wier* Universy of Alberta July 13, 2015 Abstract We examine whether the adoption of IFRS in Canada affected the structuring of convertible debt agreements. IFRS adoption in 2011 resulted in several significant changes in the accounting for convertible debt, including the requirement to classify the holder s conversion option as a derivative liabily under certain prescribed circumstances. We find that under IFRS, firms are less likely to include provisions in their convertible debt agreements that would necessate derivative liabily classification. The effect is particularly evident for highly levered firms, firms wh large convertible debt issues, and firms wh volatile returns. We also find that firms in extractive industries and firms wh private debt agreements use terms that necessate derivative liabily treatment post-ifrs. Addionally, we find that the implementation of IFRS is less likely to decrease use of these terms for firms in extractive industries. We find no evidence that management manipulates reporting of the derivative liabily. In fact, after controlling for option pricing fundamentals, the portion of the proceeds assigned to the derivative liabily conversion option is higher post-ifrs than is the portion of the proceeds assigned to the conversion option for comparable pre-ifrs issues. Moreover, the relation between the volatily of the firm s stock and the reported conversion option strengthens under IFRS. Overall, we find that some Canadian firms changed the way they structured their convertible debt agreements after the adoption of IFRS, but did not use the flexibily inherent in IFRS to engage in opportunistic reporting. * Corresponding author Esplin (aesplin@ualberta.ca), Mashruwala (cmashruw@ualberta.ca), and Wier (heather.wier@ualberta.ca) are from the Department of Accounting at the Alberta School of Business. Huson (mark.huson@ualberta.ca) is from the Department of Finance at the Alberta School of Business. Huson acknowledges support from the Pocklington Chair in Free Enterprise. We thank Lukas Roth and workshop participants at the Universy of Waterloo, the 2015 European Accounting Association Annual Congress and the 2015 Canadian Academic Accounting Association Annual Meeting for helpful comments and suggestions. We also thank John Geary and Di Xing for their excellent research assistance.

2 1. Introduction Wh the advent of International Financial Reporting Standards (IFRS) in Canada for fiscal years ending on or after December 31, 2011, Canadian firms face new rules for convertible debt reporting. As described in more detail in Section 2, these new rules include the requirement to classify the holder s conversion option, which was previously considered equy under Canadian Generally Accepted Accounting Principles (GAAP), as a derivative liabily in certain prescribed circumstances. Because of these changes, firms whose conversion option can no longer be classified as equy will now appear more levered even if there are no real changes to their capal structures. A large body of lerature (see e.g. Engel, Erickson, and Maydew 1999; Mills and Newberry 2005; and Scott, Wiedman, and Wier 2011) demonstrates that firms try to structure transactions to avoid reporting higher leverage. We therefore examine whether the implementation of IFRS in Canada affected firms convertible debt agreements. Specifically, we use the changes in the accounting treatment of convertible debt to address the following four research questions. First, we examine whether the implementation of IFRS decreased firms use of terms that would, under the new rules, necessate the derivative liabily treatment of the conversion option embedded in convertible debt. Second, we explore cross-sectional variation in the terms of convertible debt agreements, focusing on firm characteristics that we expect to be associated wh more/less use of terms that necessate derivative liabily classification of the conversion option under IFRS. Third, we examine whether firms allocate the proceeds of convertible debt differentially between the debt portion of the instrument and the conversion option pre-ifrs (where the conversion option is always classified as equy) and post-ifrs (where this option can be classified as equy or debt, depending on the circumstances). Finally, we examine whether the relation between the volatily of the firm s stock price and the reported conversion option changes after the adoption of IFRS. Focusing on convertible debt reporting around the adoption of IFRS in Canada provides a good setting in which to examine transaction structuring because (1) the accounting for convertible debt underwent significant changes wh the advent of IFRS and (2) under both the 1

3 current and previous Canadian accounting standards, there is variation in how firms report their convertible debt in the financial statements. That is, Canadian firms have choices about which terms to include in their convertible debt agreements and those terms determine how the conversion option is reported in the financial statements. This is in contrast to U.S. GAAP, for example, whereby the entire convertible debt issue is generally recorded as a liabily. Our main findings are as follows: After the implementation of IFRS, Canadian firms decrease their use of terms that necessate derivative liabily treatment for the conversion option. The decreased use of terms that necessate derivative liabily classification post-ifrs is most evident for large convertible debt issues, highly levered firms, and firms wh volatile stock prices. These are the firms for which the derivative liabily classification is likely to have the highest financial reporting costs. On the other hand, for reasons which we subsequently explain, the use of terms that necessate derivative liabily treatment post-ifrs is more prevalent among firms in the extractive industries and for private debt agreements. Further, we find that IFRS has less of an impact on firms choice of contracting terms for firms in extractive industries. Finally, although we observe decreased use of terms requiring derivative liabily classification, particularly when financial reporting costs are high, we observe no evidence that management attempts to lower leverage by manipulating the reporting of the derivative liabily. In fact, we observe the contrary: after controlling for option pricing fundamentals, the portion of the proceeds assigned to the conversion option is higher after the implementation of IFRS than is the portion of the proceeds assigned to the conversion option for comparable pre-ifrs issues. Further, for reasons explained subsequently, the relation between the volatily of the firm s stock and the reported conversion option strengthens under IFRS. We make the following three contributions to the lerature. First, we add to the lerature on transaction structuring (see e.g. Engel, Erickson, and Maydew, 1999; Marquadt and Wiedman, 2005; and Scott, Wiedman, and Wier, 2011). We find decreased use of terms that would necessate derivative liabily treatment for the conversion option post-ifrs, and document how this decreased use is associated wh firm characteristics. These results provide 2

4 what we believe to be the first evidence that IFRS induced changes in the way firms structure their debt agreements. 1 Addionally, we believe that our identification of stock price volatily as a constraining factor on the terms included in convertible debt issues is a new contribution to the lerature on the transaction structuring of hybrid instruments, which to date has focused mainly on the effect of balance sheet classification on leverage ratios. Second, our identification of firm and issuance characteristics that continue to be associated wh terms that necessate the derivative liabily treatment of the conversion option post-ifrs helps to underscore the lims to transaction structuring. Firms need to trade off financial reporting costs wh real effects, and if these real effects are sufficiently material, they overshadow financial reporting concerns. Finally, although we cannot definively rule out managerial manipulation, our results suggest that our sample firms are trying to apply IFRS fairly, despe financial reporting costs. This result provides a counter example to the many instances of income statement and balance sheet management documented in the lerature. The paper is organized as follows: Section 2 describes the accounting rules for convertible debt reporting pre- and post-ifrs. Section 3 develops our hypotheses and describes our research design. Section 4 presents our sample selection procedures, descriptive statistics, and the results of our analysis. Section 5 concludes. 2. Accounting for Convertible Debt 2.1. Canadian GAAP Pre-IFRS, the Canadian Association of Chartered Accountants (CICA) Handbook Section 3863 Financial Instruments - Presentation did not prescribe any particular method of allocating proceeds between the liabily (debt) and equy (conversion option) components of convertible debt. Instead, the Handbook had two suggested approaches. First, firms could spl the proceeds 1 In contrast, Henderson and O Brien (2015) study leasing transactions pre- and post-ifrs and find no evidence that the removal of bright lines in the leasing standard under IFRS changed how firms structured their operating leases. 3

5 of hybrid financial instruments such as convertible debt by measuring the more easily measurable portion of the instrument first (typically the debt instrument), wh the less easily measurable portion (typically the conversion option) assigned to the residual. 2 Second, firms could value both the debt portion and the conversion option, and allocate these amounts on a prorata basis so that the sum of the components equals the proceeds. In our examination of firms pre-ifrs financial statements, we find that most firms followed the first suggestion and measured the debt potion of the instrument first, assigning the residual to the conversion option. Apart from the suggested treatment of the conversion option, the CICA Handbook did not provide guidance on the treatment of any other options embedded in convertible debt. CICA Handbook Section 3862 Financial Instruments mandated only that if a hybrid financial instrument contained multiple embedded derivatives, such as call or put options, the firm should disclose the existence of these features. This lack of guidance, combined wh the Handbook s suggestion of the residual approach as a valuation technique, implies that the net value of these other options is captured in the residual component. Thus, prior to IFRS, the value of these other options was lumped wh the value of the conversion option. After the proceeds were allocated, the value inially ascribed to the conversion option was placed into equy and this dollar amount remained on the balance sheet until conversion. The debt portion of the convertible debt was carried on the balance sheet at amortized cost. Finally, Canadian GAAP allowed firms to report debt that firms classified as held for trading at fair value. The held for trading classification was reserved for short-term securies. Canadian GAAP contained no specific provisions about fair value and convertible debt IFRS induced changes Classifying Proceeds of Convertible Debt 2 CICA Handbook Section 3863, paragraph 21(a). Under the approach of valuing the debt first, the CICA Handbook states that the issuer should determine the amount of the liabily by discounting the stream of future payments of principal and interest at the prevailing rate for a similar liabily that does not have an associated equy component. The excess of the proceeds over the debt component is then assigned to the equy conversion option. 4

6 The IFRS financial reporting requirements for convertible debt apply to all debt outstanding independent of the year in which was issued. IFRS reduces the abily to classify the proceeds of convertible debt as equy. International Accounting Standard (IAS) 32 Financial Instruments: Presentation specifies a number of condions under which the conversion option must be classified as a derivative liabily (DL) rather than as equy. 3 Two of these condions relate to choices the firm can make and the third relates to the issuer s organizational form. We discuss these circumstances below. One condion that gives rise to DL classification is the presence of a cash conversion option. IAS 32 stipulates that if one of the parties to a contract has the option to settle the contract in cash, that contract is a financial asset or a financial liabily. The equy classification is therefore unavailable to the issuer of convertible debt unless the only settlement option is in equy. 4 The Board s intent is to prevent enties from circumventing the accounting requirements for financial assets and/or liabilies simply by including an option to pay in equy. A second reason for DL classification arises when the equy payout to the holder of the debt violates what the IASB refers to as the fixed for fixed condion. The primary example of fixed for fixed violation ced in IAS 32 focuses on the suation whereby the conversion option is not specified as a fixed number of shares. 5 None of our sample firms violate this condion. However, the standard also states that, if the conversion option is denominated in any currency other than the company s functional currency, the amount of consideration to be received in the functional currency is variable. This is also considered a violation of the fixed for fixed condion and requires DL treatment for the conversion option. Moreover, even if foreign-denominated debt is convertible into equy at a strike price denominated in the foreign currency, the conversion option must be classified as a DL. IAS 32 mandates DL classification for derivative contracts that may be settled by an enty delivering a fixed number of s own 3 From this point forward, we shorten derivative liabily to DL for reasons of parsimony. 4 IAS 32, paragraphs, IAS 32, paragraph 21 5

7 equy in exchange for a fixed value in a foreign currency. 6 These provisions effectively require that firms issuing any convertible debt denominated in a currency other than the company s functional currency classify the conversion option as a DL. All of our sample firms that violate the fixed for fixed condion do so solely on the grounds that they issued foreign-denominated convertible debt. A final reason why the embedded conversion option requires DL classification relates to income trust or real estate investment trust (REIT) issues. IAS 32 states that a chain of contractual rights or obligations meets the definion of a financial liabily if will ultimately lead to the payment of cash. In some instances, REIT or income trust uns are themselves redeemable into cash. Therefore, the right to convert bonds into redeemable uns is the beginning of a chain that can ultimately lead to a cash payment, and thus the conversion option is classified as a DL. Income trusts and REITs cannot restructure terms in their convertible debt to avoid treating the conversion option as a DL Valuing Individual Components of Convertible Debt Under IFRS, if the conversion option is recorded in equy, the value inially placed on the conversion option remains on the balance sheet as equy until conversion. This is consistent wh the pre-ifrs treatment. However, when the conversion option is booked as a DL, firms must mark the DL to fair value at every balance sheet date, and report the change in fair value through prof and loss. Under eher treatment, the debt portion of the convertible debt continues to be carried at amortized cost unless the company opts to fair value the entire debt issue as described in Section In addion, IFRS provides more specific guidance about the valuation of the components of convertible debt. Convertible debt typically contains a number of embedded options aside from the conversion option wh most issues including a call option on the part of the issuer 6 IAS 32, paragraph 11 (b) (ii) E3 6

8 and some also containing a put option on the part of the holder. Below we discuss the valuation of these embedded options, as well as the order in which the components of the debt are valued. If the conversion option is recorded in equy, firms are required to value the debt portion of the instrument first and then assign the residual to equy. Moreover, IAS 32 states that when carrying out the inial valuation of a compound financial instrument whose conversion option is treated as equy, the value of any addional derivative features (e.g., the firm s call option) should be recorded in the liabily component. 7 This is a significant departure from the pre-ifrs treatment, where the values of all embedded options are recorded in the residual component, which was typically equy. Firms whose conversion option is deemed to be a DL must value this liabily first and assign the residual to the debt portion of the instrument. Addionally, IFRS provides guidance on the treatment of embedded options other than the equy conversion option. For example, IAS 39 states that any option other than the holder s conversion option should be accounted for separately only if the economic characteristics and risks of the embedded derivative are not deemed to be closely related to the host contract. 8 To the extent that these derivatives are not accounted for separately, their value will end up recorded in the debt portion of the instrument because this is the residual component. The amount that an investor will pay for convertible debt is the sum of the value of the individual components of the convertible debt, after incorporation of the effects of any value interdependencies among the components. 9 Thus, the debt proceeds will reflect the value of all embedded options, regardless of whether or not they are separately identified for financial accounting purposes. To the extent that an option is not recorded separately, s value will end up 7 IAS 32, paragraphs IAS 39, paragraph 1. IAS 9 contains guidance on what constute economic characteristics and risks that are or are not closely related to the host contract. Embedded derivatives that are not closely related to the host contract should be valued and reported separately from the host contract under IFRS. A call or put option embedded in a debt host contract may or may not be closely related to the host contract, depending on s structure. A call or put option is deemed to be closely related to the host contract if the option s exercise price is approximately equal on each exercise date to the amortized cost of the host debt instrument. 9 We later discuss this point in more detail. For further details, see Barth, Landsman, and Rendleman (2000). 7

9 assigned to the residual portion of the convertible debt. Pre-IFRS, the residual is typically the conversion option, which is classified as equy. Post IFRS, the residual is typically the debt component. The order of valuation and what is therefore included in the residual becomes important when looking at the relative values of the components of convertible debt in the preand post-ifrs periods (as discussed in Section 3) Fair Valuing Entire Debt Instrument Under IFRS, companies can carry convertible debt at fair value whout designating as held for trading. If a company makes this choice for convertible debt, does not spl out the fair value of the conversion option, but rather reports a single fair value for the entire convertible debt instrument under the liabily classification in the balance sheet, wh unrealized gains or losses flowing through the income statement. IFRS uses the acronym FVTPL (fair value through prof and loss) for this treatment. We include the description of this accounting treatment for purposes of completeness, but do not formulate any hypotheses related to the fair value option. We subsequently document as part of our discussion of the descriptive statistics that choice of the full fair value option is largely limed to real estate investment trusts. Appendix A summarizes the accounting rules for convertible debt pre- and post-ifrs. 3. Hypothesis Development and Research Design Prior accounting research demonstrates that firms will go to considerable lengths to structure transactions for their desired accounting effect, which includes the intent to minimize reported leverage. Imhoff and Thomas (1988) show that the use of capal leases declined sharply after the implementation of Statement of Financial Accounting Standard (SFAS) 13, which mandated the reporting of capal leases on the balance sheet as assets and liabilies. Engel, Erickson, and Maydew (1999) examine the issue of trust preferred stock, which was treated as preferred stock for financial reporting purposes, but as debt for tax purposes. The authors find that firms paid from $10 to $43 million to substute trust preferred stock for debt, wh the 8

10 apparent motive of reducing reported leverage. Mills and Newberry (2005) use book-tax differences to develop a proxy for a firm s use of off-balance sheet and hybrid debt financing, and find that firms wh lower bond-ratings and/or higher leverage ratios are more likely to use such financing arrangements. Scott, Wiedman, and Wier (2011) find evidence that Canadian firms issuing convertible debt over the period 1996 to 2003 structured their issuances to minimize reported leverage by taking advantage of the provisions in Canadian GAAP during this time period that allowed equy classification for any portion of convertible debt that was potentially payable in a fixed number of the company s shares. In the first set of hypotheses discussed below, we focus on the choice firms make about which terms to include in their convertible debt agreements. The second set of hypotheses focuses on the allocation of the proceeds of convertible debt issues. 3.1 Choice of Terms in Convertible Debt Agreements The findings of the research discussed above lead to the following hypothesis: H1: Post-IFRS, firms are less likely to include terms in the convertible debt agreement that will necessate DL treatment for the conversion option. Our tests of H1 compare the pre- and post-ifrs periods by examining the frequency wh which firms include terms in their convertible debt agreements that would necessate DL treatment under IFRS. We look at these terms both collectively and individually and expect the use of these terms to decrease following the adoption of IFRS. We next consider why firms would choose to include a cash conversion option or terms that violate IFRS fixed for fixed condion in their convertible debt agreements. As we document later in the paper, although IFRS caused a reduction in the use of these terms, did not eliminate them. Certain firms must therefore see benefs to the continued use of these features in their convertible debt agreements, despe the financial reporting costs imposed by IFRS. We identify two characteristics that we believe to be associated wh firm choice of terms 9

11 in the convertible debt agreement that necessate DL treatment of the conversion option post- IFRS: (1) private debt agreements and (2) membership in an extractive industry. Firm choice to settle convertible debt in cash is interesting because settlement in cash runs contrary to the theory that convertible debt is eher staged financing (Cornelli and Yosha 2003) or back door equy financing (Stein 1992). We pos that use of the cash conversion option will be most prevalent for private debt agreements where both firms and investors have reasons to prefer cash settlement. Consider private debt agreements where holders are less widely dispersed. The firm would prefer to settle in cash if settlement in shares would give the convertible debt holder a sufficient block of voting shares to influence the management of the company. The investor in private debt might prefer cash settlement to the accumulation of what is likely to be an illiquid block of shares that might necessate costly filings as a controlling shareholder. The cash conversion option lowers the firm s cost of completing what is ostensibly a targeted share repurchase. As an example, Detour Gold Corporation, who issued convertible notes in a private placement, states in s 2011 annual report that the purpose of the cash conversion option is to ensure that the holders of the Class A Notes did not beneficially own 20% or more of the Company s common shares. Firms in the extractive industries typically have substantial US dollar revenue and, thus, are likely to issue foreign-denominated debt to hedge foreign cash flows. This should result in higher use of terms requiring DL treatment for two reasons. First, as discussed in Section 2.2.1, foreign denominated convertible debt violates the fixed for fixed requirement for equy treatment of the conversion option. Second, extractive industries might make higher use of the cash conversion options for two reasons. Investors buying US dollar denominated instruments are unlikely to desire a posion in Canadian dollar denominated equy. The cash conversion option provides the firm wh a low cost method of providing a US dollar denominated payout to s US dollar based investors. Addionally, unlike high-intangible firms who are continually innovating, firms in the extractive industries may have terminal growth options that do not need the permanence of equy financing. Consequently, the board of directors of firms in extractive 10

12 industries may prefer the inclusion of a cash conversion option in convertible debt as a means of liming managers access to excess cash, thereby reducing agency problems associated wh free cash flow (Easterbrook, 1984; Jensen, 1986). In addion to the arguments above, discussions wh a convertible debt expert at a major Canadian investment bank suggest an alternative rationale for IFRS having a less pronounced impact on the use of terms requiring DL treatment of conversion options for firms in extractive industries. He told us that many firms are reluctant to continue using the cash conversion option post-ifrs due to the potential volatily introduced into the income statement by revaluing the derivative liabily at each financial statement date. However, he noted that since firms in extractive industries tend not to be valued based on earnings multiples, the mark-to-market treatment of embedded DLs and s related income statement impact are of less concern to them. This suggests that despe homogenous financial reporting treatment across industries, financial reporting costs can vary due to heterogeney in the use of the numbers affected by IFRS. The above arguments suggest two things. First, in the pre-ifrs period, terms requiring DL treatment should be more prevalent in private debt agreements and in convertible debt issued by firms in extractive industries. Second, the benefs of these terms will offset the financial reporting costs of DL treatment post-ifrs. This leads to the following hypotheses: Both pre- and post-ifrs, the likelihood of including terms in the convertible debt agreement that will necessate DL treatment for the conversion option is: H2a: Higher for private debt issues. H2b: Higher for firms in extractive industries. In the next set of hypotheses (H2c-H2f), we focus on cross-sectional variation in firm choice to include certain terms in their convertible debt agreements. We look at both financial and non-financial characteristics that may influence the nature of the convertible debt agreement. When issuing debt, a firm will trade off the financial reporting costs and the real economic effects of the terms included in the indenture. We therefore expect that firms for whom the financial reporting costs of DL treatment are the highest to be the most likely to avoid terms 11

13 that necessate this treatment. The lerature discussed earlier indicates that firms are cognizant of the financial reporting costs associated wh the amount of on-balance sheet debt. Marquardt and Wiedman (2005) focus on the potential income statement effects of convertible debt, and show that US firms structured their contingently convertible bond transactions to manage diluted EPS. In subsequent research, Marquardt and Wiedman (2007) demonstrate that firms are more likely to restructure or redeem contingently convertible bonds when their effect on diluted EPS is more unfavorable and when this metric is used in the determination of CEO bonus compensation. We therefore expect firms to be conscious of the financial reporting costs associated wh both the balance sheet and the income statement disclosure of convertible debt. We identify four factors that are likely to be indicative of high financial reporting costs: high leverage prior to consideration of the convertible debt, convertible debt issues that are material to the firm, low prior income, and high stock price volatily. The former two characteristics reflect financial reporting costs associated wh high leverage, while the latter two reflect financial reporting costs associated wh the volatily induced in the financial statements by the marking to market of the derivative liabily at period-end. We expect the financial reporting costs associated wh DL treatment to be higher for large debt issues and/or longer-lived debt agreements, since large debt issues (longer-lived debt issues) have a greater (lengthier) effect on leverage. We also expect firms that are highly levered to begin wh to be more concerned about including terms in their convertible debt agreements that would necessate DL classification of the conversion option and, therefore, increase reported leverage. Moreover, we expect the cost of potential income statement volatily to be higher for low-income firms, since volatily in net income can more easily drive low-income firms into a loss posion. We also expect the extent of potential income statement volatily to be higher for firms whose stock price is more volatile, since fair value gains and losses flowing through net income on the revaluation of the derivative liabily will vary in magnude wh the volatily in the firm s stock price. This reasoning leads to the following hypotheses: 12

14 Post-IFRS, the likelihood of including terms in the convertible debt agreement that will necessate DL treatment for the conversion option is: H2c: Decreasing in the potential impact of the debt issue, where impact is defined as both the size and the length of the debt issue. H2d: Decreasing in the firm s leverage. H2e: Increasing in the firm s profabily H2f: Decreasing in the volatily of the firm s stock price. We conduct our tests of H1 and H2 using two sub-samples: (1) firms who use DL treatment due to the presence of a cash conversion option and (2) firms who use DL treatment due to eher a cash conversion option or the issuance of foreign-denominated debt. 10 Our comparison group for all tests consists of firms whose terms allow classification of the conversion option as equy under IFRS. We expect the main IFRS effect to be stronger in the first sub-sample above. Use of a cash conversion option is most crical in instances where conversion will give debt-holders a large enough block of voting shares to influence company policy. Given the addional reporting costs faced by these firms under IFRS, some firms may reconsider use of this option for debt issuances unless the potential block of voting shares to be issued on conversion is clearly material. On the other hand, firms who issue debt in a foreign currency likely do so to hedge foreign cash flows. While the financial reporting costs of classifying the conversion option as a DL could dominate the real effect of a currency hedge for some firms, foregoing the currency hedge may be sufficiently costly to act as a migating force. The effect of IFRS on use of the cash conversion option and the issuance of foreign-denominated debt is, however an empirical question, so we use both groups in our tests. We estimate the following prob model to test H1 and H2a through H2f: CHOICE = α + β IFRS + β PRIVATE + β EXT _ IND + β PROCEEDS + β OPEN _ DEBT + β ROA + β VOL + β SIZE + β IFRS PRIVATE 6 + β IFRS EXT _ IND + β IFRS PROCEEDS + β IFRS MATURITY 11 + β IFRS OPEN _ DEBT + β IFRS ROA + β IFRS VOL + β IFRS SIZE + ε β MATURITY 5 17 (1) 10 We exclude from tests of H2 firms who are required to classify the conversion option as a DL because of REIT/income trust issues. These firms cannot avoid liabily classification by altering the terms in their convertible debt agreements and their inclusion would therefore simply add noise to our choice model. 13

15 For firms using terms requiring DL (equy) treatment of the conversion option, we code the binary outcome variable CHOICE = 1 (CHOICE = 0). We measure the materialy of the debt issue to the balance sheet wh the variable PROCEEDS. 11 The MATURITY of the issue measures the maximum length of time (in months) that the firm will report a DL. 12 ROA is opening income before extraordinary ems scaled by opening total assets. 13 EXT_IND is an indicator variable equal to 1 if the firm is a member of an extractive industry and 0 otherwise. 14 OPEN_DEBT and PROCEEDS are highly correlated, and thus we include only one of these variables in any model. We control for firm size (TOTAL ASSETS), defined as opening total assets, because larger firms may have the abily to structure more complex convertible debt offerings. All of the remaining variables are defined in Appendix B. We demean all of the variables except PRIVATE and EXT_IND so that the estimate on the IFRS indicator measures the impact of IFRS adoption for a firm wh average characteristics. Estimates of β 1 tell us about the impact of IFRS adoption on a firm wh average attributes that has public debt and is not a member of the extractive industry. Hypothesis 1 predicts that β 1 is negative. We expect β 2 and β 3 to be posive if firms wh private debt agreements and firms in extractive industries are more likely to include terms necessating DL treatment in their debt agreements. Further, since the use of terms that result in DL treatment is fundamental to the nature of eher the debt agreement or the firm s assets, the impact of IFRS on the way that these firms structure the terms in their convertible debt agreements should be less pronounced than the effect of IFRS on our other sample firms. Thus, we conjecture that the coefficients on the 11 The proceeds on the debt issue exceed the amount assigned to the conversion option. However, since the amount assigned to the conversion option reflects managerial choice, we prefer to measure the proceeds because these are objectively determined. 12 The time to matury overstates the potential life of the conversion option because the debt may be called early or converted prior to matury. 13 We acknowledge that a more appropriate ROA measure would be prior income scaled by opening total assets lagged back two periods such that the denominator is measured in the period prior to the income. We do not use this methodology, however, since we lose observations when we lag the data back one more year. 14 We hand-check all of these observations to eliminate firms that are primarily energy service suppliers (two observations). Our inferences remain the same if we include these observations. 14

16 interaction of IFRS wh both PRIVATE and EXT_IND (β 10 and β 11 ) will be posive. We also expect β 12, β 13, and β 14 to be negative if firms wh greater opening leverage, larger convertible debt issues, and longer-lived convertible debt agreements, respectively, are less likely to include terms in their convertible debt agreements that necessate DL treatment post-ifrs. 15 Firms who are far away from a loss posion can absorb the potential increase in income volatily induced by the revaluation of the DL whout fear of reporting losses and thus we expect β 15 to be posive. We expect firms wh more volatile stock prices to be more hesant to employ terms that will necessate DL treatment post-ifrs, because the requirement to fair value the DL each reporting period wh the gain or loss flowing through income is more likely to cause non-predictable fluctuations in income for these firms. We therefore expect β 16 to be negative. 3.2 Allocation of the Proceeds of Convertible Debt Issues Our final two hypotheses deal wh the allocation of the proceeds of a convertible debt issue between the conversion option and the debt portion of the instrument, and the relation between the reported conversion option and option pricing parameters, most particularly the volatily parameter. We consider how both management incentives and changing reporting requirements affect the relative proportions assigned to the debt and embedded derivative components in the pre- and post-ifrs periods. We first discuss how management incentives could affect the proportion of the proceeds allocated to the conversion option under IFRS. Recall that prior to IFRS, all firms recorded the conversion option as equy and incentives to minimize reported leverage would lead managers to record the conversion option at the highest amount feasible. Post-IFRS, firms that issue bonds that allow equy treatment for the conversion option still face pre-ifrs incentives. However after IFRS, incentives have changed for firms that are required to use DL treatment for the conversion option. In order to minimize the amount of outstanding debt that is marked-to- 15 We address issues of tests of interactions in non-linear models when discussing our results. 15

17 market, these firms might manage the DL portion of convertible debt to keep as low as possible. This line of reasoning would predict that the portion of the proceeds assigned to the conversion option will be lower post-ifrs (compared to pre-ifrs) when the convertible debt contains terms that imply DL treatment under IFRS. However, changing reporting requirements under IFRS could migate this effect. One potential confounding factor is how a convertible debt instrument s embedded derivatives other than the conversion option are classified pre- and post-ifrs. As explained in Section and summarized in Appendix A, the value of embedded derivatives other than the holder s conversion option was included in equy as part of the recorded value of the conversion option pre-ifrs, and in debt as part of the debt portion of the convertible instrument post-ifrs. The direction in which the reporting classification of other embedded derivatives affects the recorded value of the conversion option depends upon whether these other embedded derivatives increase or reduce the value of the conversion option to the holder. Call options reduce the value to the holder because they give the issuer a choice over which the holder has no control. By contrast, options that allow the holder to put the debt back to the company increase the value to the holder. The financial statement notes for our sample firms mention the existence of a call option for the majory of our sample firms, and the existence of a put option for only 15% of our sample firms. While the details of other embedded options provided in the notes may not be exhaustive, we believe that the notes provide clear evidence of the prevalence of call options over put options. Thus, as further explained below, the IFRS-induced changes in the reporting for convertible debt imply an increase in the recorded value of the conversion option post-ifrs, when the value of call options swches from being netted against the recorded value of the conversion option to being netted against the recorded value of debt. Both Barth et al. (2000) and Botosan, Koonce, Ryan, Stone and Whalen (2005) discuss the interdependence of the call option and the holder s conversion option. These authors argue that the existence of a call option reduces the value of the holder s conversion option, while the existence of the conversion option raises the value of the call option by the same amount. To the 16

18 extent that the value of the call option ends up recorded in equy, s value is netted against that of the holder s conversion option. Thus, the interdependent portion of these options cancels out in the accounting valuation. However, post-ifrs, the value of the call option is netted against the debt value. Consequently, in the absence of opportunistic reporting, the recorded value of the conversion option is higher under IFRS. This prediction goes in the oppose direction for put options; however, as noted above, put options are far less frequent in our sample firms than call options. Like call options, cash conversions reduce the value of the holder s conversion option because they provide the issuer a choice over which the holder has no control. The general guidance provided by IAS 39 suggests that a cash conversion option should be valued separately unless s value is closely tied to the value of the debt contract. However, in reading the notes to the financial statements for all of the convertible debt issuances in our sample, none of them (even those that describe the valuation procedure in detail) allude to separate consideration of the value of the cash conversion option in the recorded accounting valuations. Addionally, we spoke wh a convertible bond specialist at a major Canadian investment bank, who told us that issuers do not separately value the cash conversion option. To the extent that cash conversion options are treated as part of the residual valuation, they will push down the recorded value of the conversion option pre-ifrs, but will not affect the recorded value of the conversion option post-ifrs. Thus, as wh call options, we expect the change in financial reporting to result in a relatively higher proportion of the proceeds recorded as the conversion option post-ifrs. Further, unlike call options, which are netted against the debt portion of the instrument for all convertible debt post-ifrs, the cash conversion option only exists for convertible debt instruments necessating DL treatment. This suggests that the portion of proceeds assigned to the conversion option will be particularly high post-ifrs for convertible debt issues necessating DL treatment. Based on the above discussion, we expect the percentage of the proceeds assigned to the conversion option to change pre- and post-ifrs. If management s desire to decrease reported 17

19 leverage dominates, we would expect to see a smaller amount of proceeds assigned to the conversion option post-ifrs when that option must be recorded as a DL. On the other hand, if the change in accounting requirements due to the adoption of IFRS dominates, we would expect a greater amount of proceeds to be assigned to firms wh a DL conversion option post-ifrs. The above discussion leads to the following two-tailed hypothesis: H3: Post-IFRS, the average percentage assigned to the conversion option changes relative to the pre-ifrs valuation for firms wh convertible debt whose terms would imply DL treatment under IFRS. Our final hypothesis focuses on whether, and how, the relation between the reported value of the conversion option and the volatily of the underlying stock changes around the adoption of IFRS. In related work, Bartov, Mohanram, and Nissim (2007) examine US firms selection of the volatily parameter in the valuation of employee stock options (ESOs) and find that firms take advantage of this discretion by basing their volatily estimates on the lower of historical or implied volatily, which has the effect of reducing the reported option value. 16 We focus on the volatily parameter for two reasons. First, the volatily assumption is the most important input to option valuation, since option values are highly sensive to the choice of the volatily parameter (Brenner and Subrahmanyam, 1994). Second, this is the parameter over which management has the most discretion. It is difficult for managers to exercise much discretion in their choice of the risk-free rate, which is observable. Nor is plausible for management to select a vastly different dividend yield than the current yield. The life of the option is constrained by the terms in the debt contract, and both the strike price of the embedded option and the market price of the firm s stock are observable. IFRS does not prescribe use of a historical, verifiable volatily estimate, but rather states that management may estimate volatily eher by referencing historical volatily or by estimating expected future volatily. 16 These authors focus on implied volatily, which they back out of ESOs. This approach is not viable for us because, unlike ESOs, the convertible debt issues in our sample contain a variety of embedded options other than the holder s conversion option, thus rendering their valuation much more intricate than that of a plain vanilla option. 18

20 If managers take advantage of the discretion available under IFRS in order to reduce the reported value of the DL, we would expect historical volatily to be less related to the recorded value of the conversion option in the IFRS regime because managerial opportunism is likely to weaken the relation between the recorded conversion option and option pricing fundamentals. If, however, the IFRS focus on the direct valuation of the DL as compared to the pre-ifrs valuation of this amount (as the residual of the proceeds less the debt valuation) sharpens focus on the valuation of this component, we expect historical volatily to be more related to the recorded option value post-ifrs. We expect this relation to be driven by firms that classify the conversion option as a DL under IFRS since for issues using the equy treatment the amount allocated to the conversion option is not affected by managers decisions regarding option valuation parameters eher pre- or post-ifrs. Another reason to expect the relation between option fundamentals and the recorded value of the conversion option to change for bonds requiring DL treatment is that pre-ifrs the recorded value of the conversion option was that of a portfolio of options and post-ifrs the recorded value of the conversion option is that of a single option. The relation between equy volatily and a portfolio of options is likely different than the relation between volatily and a single option. We test the following two-tailed hypothesis: H4: The relation between the recorded value of the conversion option and volatily differs pre- and post-ifrs. This difference is most apparent for issues wh terms that would require DL treatment post-ifrs. We test H4 using the following regression model, and H3 using an abbreviated version of the same model, which excludes estimation of parameters β 10 through β 12 : CONV _ OPTION = α + β IFRS + β DERIV _ LIAB + β IFRS DERIV _ LIAB + + β VOL + β DIV _ YIELD + β MONEYNESS + β RF + β MATURITY + β PROCEEDS 5 + β IFRS VOL + β DERIV _ LIAB VOL + β IFRS DERIV _ LIAB VOL + ε (2) For firms using equy accounting treatment, CONV_OPTION is measured as the value of the conversion option assigned to equy scaled by the proceeds. For firms using the DL treatment, CONV_OPTION is measured as the value of the conversion option assigned to the DL scaled by 19

21 the proceeds. We include measures of the parameters to the Black Scholes model: volatily, (VOL), dividend yield (DIV_YIELD), the extent to which the options are in the money (MONEYNESS), and the risk-free rate (RF). We also control for the size of the issue (PROCEEDS). All variables are defined in Appendix B. We use a difference-in-differences design to test H3 and H4. This controls for any economic reasons (unrelated to accounting discretion) for valuation differences between options accounted for as a DL and options accounted for as equy derivative. For example, if the firm has the option to settle the conversion in cash, this reduces the value of the option to the holder because gives the firm a choice over which the holder has no control. The coefficient on DERIV_LIAB identifies the pre-ifrs effect of the terms of the debt agreement on the reported value of the conversion option, and the coefficient on the interaction of DERIV_LIAB wh IFRS isolates the incremental effect of the changes in IFRS reporting requirements on firms whose convertible debt terms necessate DL treatment. This design takes advantage of the fact that firms for whom the structure of the conversion option implies DL treatment under IFRS did not classify the conversion option as a DL pre-ifrs. We are thus able to use pre-ifrs issuances that contain terms that would necessate DL treatment post IFRS as a control for differences in the valuation of the conversion option due to the economic nature of the option. In testing H3, the estimate of interest is β 3, the interaction of DERIV_LIAB wh IFRS. In testing H4, the estimate of interest is β 12, the three-way interaction of DERIV_LIAB, VOL, and IFRS. Since both H3 and H4 are two-sided hypotheses, we do not have a prediction on the direction of the coefficients β 3 and β 12. We test H3 and H4 using all firms who record a DL post-ifrs, including firms who use this category for REIT/income trust reasons. 17 When testing H2, we focus on firm choice, and firms who use the DL classification for REIT/income trust reasons cannot alter this classification through the structure of their convertible debt agreements. For H3 and H4, we are examining 17 Note that REITs can choose whether to spl convertible debt between debt and a conversion option, or to carry the entire debt amount at fair value (FVTPL). Our tests include only the former group. 20

22 allocation of the proceeds, so we are interested in comparing all firms who use DL treatment, regardless of the reason, wh firms who use the equy classification. 4. Sample Selection, Descriptive Statistics, and Results 4.1 Sample Selection Our sample selection procedure begins wh the identification of all Canadian firms (PRICAN > 0) that report convertible debt on Compustat in 2011 (DVCT > 0). This provides us wh a sample of 309 issuances from 230 unique firms. We eliminate 112 issuances as identified in Table 1, which leaves us wh a sample of 197 issuances in 2011 and prior years. INSERT TABLE 1 ABOUT HERE We trace the convertible debt back to the year of issuance for these 197 issuances. The earliest issuance year in our sample is The advantage of this sample selection approach (as opposed to choosing a pre-2011 year and reading all financial statements wh convertible debt issuances from that year forward) is that the accounting treatment of the settlement options post- IFRS and associated financial statement disclosures allow us to easily identify firms whose terms mandated eher DL or equy treatment for the conversion option post-ifrs. Pre-IFRS, this information was not determinable from the accounting treatment, nor did the financial statement notes necessarily provide full details on the terms of settlement. Thus, identifying the precise terms on the settlement option pre-2011 requires reading debt agreements, which we can do only for public debt. Thus, by starting wh 2011 financial statements and working backwards, our sample selection procedure does not bias again firms wh private debt agreements. We then add 50 issuances to the original sample that we identify from firms 2012 financial statements, for a final sample of 247 issuances for 230 unique firm-years. We retain 187 out of 230 firm-year observations in our tests of H1 and H2 (Table 5) after deleting firms using derivative liabily treatment for REIT/Income Trust issues and firms wh missing data. We retain 190 out of 230 firm-year observations in our tests of H3 and H4 (Table 6) after deleting firms wh missing data necessary for calculation of the option pricing parameters. 21