Does the Accounting Classification of Hybrid Financial Instruments as Debt or Equity Matter?

We examine if the economic substance or the accounting classification of corporate hybrid bonds (CHBs) as debt or equity matters for financial statement users. Our results suggest that users evaluate CHBs in line with their accounting classification, encouraging managers to align CHBs’ accounting classification with their reporting goals. Accordingly, we find that reporting incentives (eg, debt covenants, earnings targets) are positively associated with issuing equity-classified instead of debt-classified CHBs. Next, we find that equity investors price CHBs as debt at issuance, irrespective of their accounting classification. However, when subsequently recognized as equity in financial statements, CHBs are priced as equity. Lastly, we provide evidence that CHBs’ equity classification is associated with deteriorating analysts' forecast properties. Our results pertain primarily to firms not presenting CHBs separately in their financial statements. These findings support the IASB’s recent improvements regarding CHBs’ presentation and disclosure to reduce users’ awareness costs.