Financial reporting, debt covenants and convertible debts

Abstract

Purpose

This study proposes an alternative perspective on why firms issue convertible debt, to supplement the largely theoretical motives identified in the existing literature. It hypothesises that the separate presentation of convertible debt into its equity and liability components has economic consequences and advantage that explain why firms issue convertible over non-convertible debt, consistent with the debt covenant hypothesis. The purpose of this paper is to address the proposed perspective and hypothesis.

Design/methodology/approach

Data on convertible debt, gearing (debt assets and debt equity), debt issuance and retirement, etc. were collected for a sample of 1,104 firms listed on Bursa Malaysia. Regression analyses were then used to assess the hypotheses on how gearing affects the use of convertible debt and the impacts of its use on changes in gearing over the financing cycle.

Findings

Firms with higher gearing, and possibly those close to violating debt covenants, are more likely to issue convertible than non-convertible debt. In addition, the use of convertible rather than non-convertible debt both reduces the increase in gearing when debts are issued and leads to a larger decrease in gearing during debt retirements via conversion.

Practical implications

These effects on gearing provide firms with additional financial flexibility and enhance firms' capacity to borrow more from other sources, a lower-debt advantage.

Originality/value

This study demonstrates the informational role of financial reporting in addressing the stewardship emphasis, as part of the decision usefulness objective of financial reporting in the Conceptual Framework for Financial Reporting.

Citation

Lau, C.K. (2023), "Financial reporting, debt covenants and convertible debts", Asian Review of Accounting, Vol. 31 No. 2, pp. 256-275. https://doi.org/10.1108/ARA-05-2022-0126