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How Do Financial Professionals Evaluate Hybrid Financial Instruments?

Experienced finance professionals, tasked with making credit-related judgments, vary significantly in deciding which features of hybrid securities are important in determining debt versus equity. 

March 15,  2017

By Elaine Cole

Hybrid financial instruments, also known as hybrid securities, contain features of both equity and debt (stocks and bonds). The most common examples are convertible bonds and preferred stock.

Hybrid financial instruments have become increasingly popular for companies because they provide flexibility and offer a cost-effective way to raise additional capital.

From an investor’s perspective, hybrid financial instruments are attractive because they offer fixed interest payments with the potential for price appreciation in the future.

“This leaves standard setters such as the Financial Accounting Standards Board (FASB) with a perplexing issue: What is the best way to communicate the use of these hybrid instruments to financial statement users?”, said Shana Clor-Proell, associate professor of accounting at the Neeley School of Business at Texas Christian University.

Her latest research provides insights about how experienced financial statement users interpret these hybrids.

Clor-Proell and her co-authors’ paper, “How Do Experienced Users Evaluate Hybrid Financial Instruments?” was published in the December 2016 Journal of Accounting Research.

“The long-standing assumption was that experienced financial professionals would be most concerned with the balance sheet classification of hybrids, but our results show that they are largely unconcerned with classification differences when making lending judgments,” Clor-Proell said.

The experienced financial professionals in Clor-Proell’s study were more concerned with the specific features of the hybrid; however, “they showed substantial disagreement about which features are most important,” she said.

Clor-Proell’s research has implications for standard setters as they deliberate the classification and disclosure requirements for hybrid securities.

“While much of the standard-setting focus has been on proper classification, there may not be a single classification rule that all users would agree with,” she said. “It is critical that standard setters determine the most effective disclosures for these complex financial instruments.”