Heather A. Wier

Management of Note Disclosures: The Case of Unconsolidated Subsidiaries Prior to FAS No. 94:

Statement of Financial Accounting Standards Number 94 (FAS 94) requires that firms consolidate all majority-owned subsidiaries, including those that were previously exempt from consolidation requirements due to the dissimilarity of parent/subsidiary operations. Prior to FAS 94, firms disclosed summary information on unconsolidated subsidiaries in their notes. This research demonstrates that, although the overall sample is unbiased, pre–FAS 94 note disclosures were insufficient to enable users to obtain an accurate picture of consolidated leverage for a number of firms. The research also illustrates that firms that underreported subsidiary debt had significantly higher consolidated leverage (as measured using pre–FAS 94 note disclosures) than other firms and that the market appeared to have relied on these inaccurate disclosures in assessing firm value.

Transaction Structuring and Canadian Convertible Debt

We examine whether Canadian firms issuing convertible debt over the period 1996–2003 structured issuances to minimize reported leverage. Over this sample period, some firms using payment-in-kind (PIK) provisions providing them with the option to make interest and/or principal payments in company shares were able to record significant amounts of the issuance as equity. In a sample of 195 convertible debt offerings, we find significant variation in accounting treatment, ranging from firms recording the entire issuance as debt to some recording the entire issuance as equity. We find evidence consistent with the contention that reporting benefits are an important reason why high-leverage corporations with material convertible debt transactions used PIK provisions. In contrast, our evidence suggests that the future financial flexibility ensuing from the use of PIK provisions was an important determinant of income trusts’ use of this feature. We acknowledge, however, that during our sample period PIK provisions simultaneously provide both financial flexibility and reporting benefits to any issuer, whether corporation or trust. Finally, we document a negative share price reaction on the part of convertible debt issuers employing PIK provisions at the time when the likelihood of the introduction of more restrictive accounting rules increased. This negative reaction is driven by the corporations in our sample, with the income trusts largely unaffected. Our findings are relevant to standard setters as they debate alternative models for distinguishing between equity and liabilities.

An Investigation of the Value Relevance of Alternative Foreign Exchange Disclosures

We demonstrate analytically and empirically that valuing a firm with foreign operations in the presence of exchange rate uncertainty requires information on the foreign operating cash flows disaggregated by currency and persistence. In particular, given consolidated earnings, investors need information on the exchange gain or loss on permanent foreign operating cash flows. We extend the model to show how the permanent foreign cash flows can be used to condition the change in the translation adjustment to make it value relevant; however, using the permanent foreign cash flows directly is superior for valuation. The empirical tests support our hypothesis that the market response to exchange rate movements is sensitive to the relative magnitudes of revenues and costs denominated in each foreign currency in which a firm has transactions. Disclosure of cash flows by currency should enhance the valuation of firms with foreign operations.

The Explanatory Power of Canadian Accounting Measures of Earnings Dilution

This paper examines the properties of the accounting measures of dilution under pre-2001 Canadian GAAP. Fully diluted earnings per share (EPS) presents investors with a per-share figure that attempts to capture the maximum potential dilution that would occur if all dilutive convertible securities were converted and all dilutive stock options and rights exercised. We examine how the difference between basic and fully diluted EPS, which we refer to as the dilutive adjustment, affects the ability of EPS to predict one-period-ahead EPS. Moreover, we address the issue of the explanatory power of changes in the dilutive adjustment for unexpected stock returns over the year and at the earnings announcement date. Surprisingly, in contrast with the traditional accounting view that increases in the dilutive adjustment present the investor with bad news due to potential dilution of the future earnings stream, the dilutive adjustment is positively related to next periods earnings and increases in the dilutive adjustment are positively correlated with contemporaneous long-window stock returns. These results can be attributed to the relation between the dilutive adjustment and the earnings process combined with a partial resolution of the uncertainty attached to growth firms. We find no evidence that investors use information from the disclosure of fully diluted EPS at the earnings announcement date. These results are consistent with increases in the dilutive adjustment capturing the partial realization of a firms growth potential that more than outweighs the potential dilution attached to the convertible securities; however, this information appears to be already embedded in price prior to the disclosure of fully diluted EPS.