This study examines the accounting classification of convertible debt in an environment where there is the choice of debt, other capital funds or equity.
Contracting theory suggests possible determinants of accounting choice. These are leverage, as a proxy for closeness to debt covenants, the relative size of the convertible financial instrument issued and the contractual terms of the instrument. Two measures of leverage are used. One is debt to earnings before interest, tax, depreciation and amortisation (EBITDA). This variable has been included as it is the most commonly used ratio in debt covenants. The second measure is debt to net tangible assets as this ratio, or similar ratios, have been used in previous accounting studies to proxy for closeness to debt covenants. As leverage ratios tend to vary between industries I identify whether each firm is above or below their industry average. I find that the best predictor of the accounting classification choice is the contractual terms of the instrument. The two debt covenants derived hypotheses are not supported. The leverage of the issuer and the relative size of the issue have no significant influence on the choice of classification.