Common Equity Investors’ Assessments of the Dilution and Solvency Effects of Preferred Stock Instruments

ABSTRACT Generally accepted accounting principles (GAAP) requires dichotomous classification of financial claims as liabilities or equity. Classifying claims is challenging when instruments have attributes of both liabilities and equity (i.e., hybrid instruments). We examine the conditions under which common shareholders assess one class of hybrid instrument—preferred stock—as similar to liabilities or equity. Preferred stock is similar to liabilities because it is senior to common and thus payments to preferred shareholders reduce net assets available to common shareholders, negatively affecting their expected cash flows (dilution perspective). Preferred stock is similar to equity because its payments cannot cause bankruptcy; thereby, having no obligatory effect on cash flows to common (solvency perspective). We identify expected financial distress costs as the entity‐level economic characteristic that distinguishes conditions when each of these perspectives is more important to common shareholders’ assessments. We predict and generally find that common shareholders change their assessments of preferred stock from negative to zero as expected financial distress costs change from low to high, consistent with a dichotomous classification, first as liabilities, then equity. We also find a positive association between preferred stock and common equity prices for high expected financial distress firms (1) issuing additional preferred stock and (2) 1 year prior to delisting. In both situations, common shareholders would expect an increase in cash flows from preferred stock. Last, we find that common shareholders do not assess preferred stock consistent with US GAAP classification guidance that is based on economic characteristics (i.e., contractual provisions) of the instrument. Standard‐setting implications are discussed.