Investors' Assessment of Dilution and Solvency Effects of Preferred Stock Instruments

Abstract

GAAP requires dichotomous classification of financial claims as either liabilities or equity. Classifying financial claims is challenging when instruments have attributes of both liabilities and equity (i.e., hybrid instruments). In this study, we examine under what conditions that common equity investors assess one class of hybrid instruments – preferred stock – similar to liabilities or equity. Preferred stock is similar to liabilities because it is senior to common equity and thus reduces the claims of common shareholders on the net assets of the firm (a dilution perspective). Preferred stock also is similar to equity because it cannot cause bankruptcy (a solvency perspective). We identify expected financial distress costs as the entity level economic characteristic that helps distinguish conditions when each of these perspectives is more important to investors’ assessments of preferred stock. We predict and find that investors assess preferred stock similar to (1) liabilities (equity) when expected financial distress costs are low (high). Using a sample of firms that delist as an ex-post measure of financial distress, we also predict and find that investors change their assessments of preferred stock over the five years prior to delisting, increasingly assessing preferred stock more like equity as financial distress costs increase. Lastly, we find that investors do not assess preferred stock consistent with U.S. GAAP classification guidance that is based on economic characteristics (i.e., contractual provisions) of the instrument rather economic characteristics of the entity. Standard setting implications are discussed.

Keywords: preferred stock, balance sheet classification, capital structure theory, dilution versus solvency; liabilities versus equity

JEL Classification: M41, G32, M48