Balance sheet management:
The case of short-term obligations that are reclassified as long-term debt
by
§
Jeffrey D. Gramlich, Mary Lea McAnally,‡ and Jacob Thomas
*
August 1999
*
University of Hawaii at Manoa and Copenhagen Business School.
University of Texas at Austin.
§
Columbia University.
‡
The authors thank Leslie Hodder for research assistance. Helpful comments were received from Senyo Tse, Thomas
Plenborg, Christian Petersen, Lisa Koonce, Bill Kinney, Ross Jennings, Eric Hirst, Michael Clement, an anonymous
reviewer and seminar participants at the University of Texas at Austin, Texas A&M University, and Copenhagen
Business School.
1.
Introduction
We examine a possible form of balance sheet management: the initial reclassification of certain short-
term obligations, primarily commercial paper, as long-term debt, and the subsequent declassification of
those items when they are returned to the current liability section of the balance sheet. (For this purpose,
“reclassification” occurs when a firm includes some short-term obligations in the long-term liability
section of the balance sheet; “declassification” occurs when a firm no longer reclassifies in a year when it
did reclassify the year before.) Under Statement of Financial Accounting Standard No. 6 (SFAS 6) firms
may reclassify part or all of their short-term obligations as long-term debt, provided the firm states its
intent to roll over such obligations on a long-term basis and can demonstrate its ability to do so. Ability is
in evidence when the firm secures from its bank a non-cancelable loan commitment that extends beyond
the following fiscal year-end. The firm is then permitted to reclassify the short-term obligations as longterm debt.1
Why firms would undertake such a strategy is not immediately clear because reclassification has no
impact on aggregate measures of assets, liabilities, or equity, although it increases both reported liquidity
and reported leverage.2 While considerable research has examined why and how firms manage their
income statements, 3 much less attention has been paid to balance sheet management.4 Even less is known
about the incentives to manage liquidity and the classification of debt between current and long-term.
Consequently, we do not present formal hypotheses in this paper. Rather, we report a previously
undocumented financial reporting practice and propose two plausible explanations for the phenomenon.
Perhaps further research will produce a theoretical understanding of this financial reporting practice.
We examined a sample of 197 firms that reclassified short-term obligations to long-term during 1984
to 1994 and discovered that reported current ratios for reclassifying firms are increased to the extent that
they are statistically indistinguishable from 1) the level in the year prior to the reclassification, and 2) the
industry median current ratio.5 Long-term debt ratios are increased by reclassification, but not by enough
to always make reclassifiers appear more leveraged than their industry peers. We also find that when
firms subsequently declassify, their current ratios before the effects of reclassification are higher than in
1
the previous year and greater than for other firms in their industry. The declassification moves current
ratios down to time-series and industry norms. Similar, but weaker, patterns exist for leverage levels in
the years firms cease reclassifying. Additionally, we discovered that firms with current ratio or working
capital debt covenants are more likely to reclassify. This holds even after controlling for profitability,
liquidity, and leverage. Tests also show that reported covenant violations are less frequent among
reclassifying firms than among other firms in the sample.
The empirical regularities we document lead us to propose two explanations for reclassification. First,
firms that reclassify are trying to meet inter-temporal and/or cross-sectional liquidity targets. In an
environment characterized by exogenous shocks to liquidity and information asymmetry, a firm may
choose to manage its reported level of liquidity to avoid reporting lows or highs that could be
misconstrued by external constituents.6 Managers may perceive that some financial statement users rely
on the balance sheet alone for an assessment of liquidity, perhaps because users perform analyses with
quantitative electronic databases where contextual (i.e. footnote) information is not readily accessible.
Such users include, for example, financial analysts who calculate time-series trends, make inter-company
comparisons, and often use benchmarks in performing ratio analysis.
Second, reclassifying firms may be close to violating a current ratio or working capital debt covenant.
Duke and Hunt [1990] and Press and Weintrop [1990] document that working capital measured using
balance sheet numbers is a construct often specified in debt contracts. Reclassification provides a means
to move a critical covenant ratio thereby avoiding costly renegotiations or debt default. Conversations
with audit partners revealed that they would not only approve reclassification as a means to effect balance
sheet management, but would recommend it to clients facing debt-covenant violations.
2.
Data
Using the NAARS database, we identified 220 firms that reclassified short-term debt during the 1984
to 1994 period. If a firm had a reclassification at any point during the 11-year window, we collected short
2
and long-term debt footnotes for the entire period. We gathered other financial statement information
from Compustat. Our final sample contains 197 firms (1765 firm-years).
Debt footnotes were read and coded to obtain information on reclassification. We also searched for
the terms associated with supporting loan commitments or lines of credit and debt covenant information,
as well as violations thereof. A firm-year was coded as a reclassification if commercial paper, notes or
other items of debt maturing within the following year were classified as long-term pursuant to the “intent
and ability” paragraph of SFAS 6. A firm-year was coded as a declassification if the firm ceased
reclassifying all amounts during the year. Interestingly, most declassifying firms continued to use shortterm obligations as financing after declassification, choosing, however, to include the short-term
obligations in the current liability section of the balance sheet. Exhibit 1 provides an example of
reclassification disclosure taken from Form 10K.
Using Compustat data, we calculated industry benchmarks for liquidity and leverage measures. Each
firm’s benchmark is the prior year’s median ratio for the size quartile and the 2-digit SIC group to which
the firm belongs. Our use of industry benchmarks is motivated by recent empirical results that report
increasing industry specialization among financial analysts, and the superior performance of those who
specialize (Clement [1999]). Our design was also influenced by the result in Lev [1969] which suggests
that firms’ financial ratios adjust across time toward the previous year’s industry averages. Among the six
financial ratios Lev examines, the quick and current ratios exhibit the fastest and most significant
adjustments toward industry averages.
3.
Empirical Findings
Over the 1984-94 sample period, half the firm-years have short-term obligations reclassified as long-
term, and reclassification lasted five years on average. The size of reclassified liabilities is substantial for
firms that reclassify: on average, 29.1 percent of long-term debt consists of reclassified current
obligations and the amount reclassified averages $329 million. In the years they reclassify, reclassifying
3
firms are on average larger, more leveraged, less liquid, and more profitable than sample firms in their
non-reclassifying years.7
3.1 UNIVARIATE COMPARISON AGAINST PRIOR YEARS
Figure 1 shows the mean current ratio with and without the effects of SFAS 6 reclassification.8 Initial
reclassifiers (Panel A) would have experienced a significant decline in their current ratio absent a
reclassification. The mean current ratio is 1.20 before the effects of reclassification compared to a ratio of
1.50 after the reclassification. In fact, in the three years prior to initial reclassification, firms experience a
steady decline in their current ratio.
On the other hand, declassifiers’ current ratio strengthens considerably in the year of the
declassification (Panel B). It is not empirically possible to estimate what the current ratio would have
been had the firm not declassified so we compare the ratios for the current and prior year, absent
reclassification. Before the effects of reclassification, the prior year’s current ratios averaged 1.21 and
was increased to 1.53 by reclassification. In the declassification year, the current ratio is 1.47 without any
benefits of reclassification. This suggests that declassification was strategically timed to occur when the
current ratio was increasing.
Tables 1 and 2 present annual statistics on the impact of reclassification and declassification.9 The
“reported” ratios use the current liability number reported on the firm’s balance sheet, i.e. after the
reclassification. The “adjusted” ratios are recalculated ratios, where the reclassified amounts are returned
to the current debt section. These tables statistically compare: 1) the reported and adjusted ratios, 2) the
change from the previous year in adjusted and reported ratios, and 3) the differences between the reported
and adjusted ratios. In addition, Table 1 compares the changes in reported and adjusted ratios between
reclassifying firms and their industry benchmark measures. For the moment, we focus on the time-series
comparison, saving the industry comparison for later. In this regard, annual changes in reported current
ratios are insignificant for most years whereas changes in adjusted current ratios are large and negative
4
(see Table 1, Panel A, test 2). Thus, the effects shown in Figure 1 appear consistently in each year of the
sample period.
By definition, reclassification increases both the current ratio and the long-term debt ratio and over
the sample period, these increases are statistically significant (p<.001). The effect of reclassification is to
increase mean current ratio by 0.32 and increase mean long-term debt ratio by 0.06.10 After considering
the effect of reclassification, reported current ratios are not significantly different from the prior year
when no reclassification occurred. Without the reclassification, however, current ratios would have
declined on average, by 0.34 (p<.001). In contrast, while reported long-term debt ratios increase in the
initial year of reclassification, after undoing the effects of the reclassification, less long-term debt was
indicated than the year before. Thus, the leverage effect of initial reclassification is mitigated by a real
decline in long-term debt (see Table 1, Panel B, test 2).
Similar to reclassification, declassification appears to be driven by a desire to smooth the current ratio
and the long-term debt ratio. Table 2, Panel A shows that in the year of declassification, reported current
ratios are not statistically different from the prior year, although adjusted current ratios increase by a
mean of 0.26 (p<.001). In the declassification year, adjusted long-term debt ratios increased by mean of
0.03 (p<.001) and reported long-term debt ratios decreased by a mean of 0.03 (p<.001). (See Table 2,
Panel B.) Indeed, if smoothing ratios is an objective, declassification also appears to be driven by firms
smoothing the current ratio, not the long-term debt ratio, and fundamental increases in the long-term debt
ratio absorb some of the decrease caused by declassification.
3.2 UNIVARIATE COMPARISON AGAINST INDUSTRY PEERS
Table 1, Panel A (test 3) reports the mean difference between a firm’s current ratio and its industry
benchmark. Reclassifiers’ reported current ratio is statistically equivalent to the industry benchmark in
every year except 1990. Thus, from a comparison of the firms’ balance sheets, reclassifiers are at the
industry norm. But when the reclassifiers’ adjusted current ratios are compared to the industry
benchmark, big differences emerge. In eight of the 10 years studied, the reclassifiers’ adjusted current
5
ratios were lower than the industry benchmarks by a significant amount. We conclude that reclassifiers
are comparatively less liquid, as indicated by lower current ratios, in their initial year of reclassification
but that reclassification obscures the difference. The fourth test on Table 1, Panel A, shows that these
lower current ratios arise from fundamental declines in adjusted current ratios during the year prior to
initial reclassification (see test 2), but that these fundamental declines did not occur for the industry
benchmark firms.
The effects of initial reclassification on long-term debt are summarized in Table 1, Panel B. Test 1
shows that reclassification significantly impacted long-term debt ratios (p<.001). Test 2 indicates that
reported long-term debt ratios increased relative to the previous year as a result of reclassification
(p<.001) while adjusted long-term debt ratios decreased (p<.05). Apparently, a fundamental decline in
long-term debt ratios helped reclassifiers absorb the increased reported leverage arising from
reclassification. Test 3 shows that, prior to the reclassification, reclassifying firms were less leveraged
overall than their industry benchmarks, and test 4 reveals that this lower leverage arose, at least in part,
from declines in the long-term debt ratio in the year preceding initial reclassification.
The subsequent declassification decision appears to be timed to coincide with strengthening liquidity.
Without considering the reclassification in the prior year, the current ratio would have increased in every
year except 1990 (see Table 2, Panel A). Shifting short-term obligations back to the current liability
section of the balance sheet decreased the current ratio (relative to what would have been reported if the
firm continued to reclassify), but the decrease is not significant (see test 1) nor is it endemic to the
industry (see test 3). From Table 2, Panel B we see that adjusted long-term debt ratios were increasing
among declassifiers (test 1, column 3) and that declassification gives the opposite impression (test 1,
column 2). After declassification, reported long-term debt ratios are not statistically different from the
industry benchmarks (Table 2, Panel B, test 2). However, test 3 reveals that declassifiers’ reported longterm debt ratios declined slightly; the non-parametric test of medians is significant, but the parametric test
of means is not. If declassifying firms had not reclassified in the previous year, their long-term debt ratios
would have increased (p<.01).
6
To summarize, declassification resulted in smoothing the current ratio across time and relative to
industry benchmark firms. Further, declassification, which has the effect of decreasing long-term debt
ratios, appears to have been timed to occur in years when long-term debt ratios were increasing.
3.3 MULTIVARIATE ANALYSES
To explore what factors jointly affect the reclassification decision, we estimated multivariate logistic
regressions. Independent variables included levels and year-over-year changes in liquidity, leverage, and
profitability where all the variables are defined to exclude the effects of reclassification. Our findings, not
presented in detail here, are significant: the models correctly predict between 74 and 90 percent of the
reclassification and declassification decisions represented by the sample firm-years. Estimated
coefficients reveal that the smaller a firm’s current ratio and the larger the decrease in the current ratio
before the effects of reclassification, the more likely the firm is to reclassify. In addition, firms are more
likely to reclassify when current liabilities are high but long-term liabilities are low. Profitability is not
associated with either the reclassification or the declassification decisions.
When liquidity and leverage variables are defined relative to industry benchmarks (to test for crosssectional smoothing), current ratio and changes in current ratio remain the most significant factors in the
reclassification and declassification decisions. Interestingly, leverage becomes much more significant for
declassifiers, consistent with the notion that these firms smooth to industry norms but not to time-series
targets.
We estimated ordinary least squares regressions and determined that the dollar amount of reclassified
short-term obligations is negatively related to liquidity, leverage, and profitability. We tested both the
time-series and the cross-sectional smoothing models and the results were largely the same. Measures of
R2 range from .25 to .35, and the coefficients of interest are highly significant. Firms appear to make
considered choices in both the reclassification decision as well as the dollar amount reclassified.
7
3.4
DEBT COVENANTS AND RECLASSIFICATION
Although 36 percent of the firm-years in our sample disclosed current ratio or working capital
covenants, few of these were quantified. Tests of means showed that reported and adjusted current ratios
of firms disclosing working capital or current ratio covenants were significantly higher than those of firms
that did not disclose such covenants. Frequency tables revealed that a higher proportion of these firms
reclassified than statistically expected. We performed logistic and OLS regressions and included dummy
variables for the existence of liquidity based constraints, and find that firms with such covenants are
significantly more likely to reclassify (and reclassify greater dollar amounts) after controlling for
profitability, liquidity and leverage. We also included in the regressions a dummy variable to capture debt
covenant violations reported in the debt footnote. In the logit and OLS regressions, the violations variable
was not significant. However, when the OLS regressions were re-run on the sub-sample of firms whose
footnotes mentioned current ratio or working capital covenants, we found a strong negative association of
violation with the amount reclassified. Thus, firms whose footnotes reported liquidity-based covenants,
but not covenant violations, reclassified more short-term obligations as long-term debt. One possibility is
that these firms effectively used reclassification to avoid covenant violations.
4.
Conclusion
We find that both reclassification and declassification have the effect of smoothing liquidity and
leverage measures reported on the balance sheet. Short-term obligations reclassified as long-term debt
smooth liquidity measures in a time-series and cross-sectional sense. Initial reclassifications are
associated with deteriorating current ratios when measured against last year’s level or against an industry
benchmark. Repeat reclassifiers report smooth, but low, liquidity ratios during the term of their
reclassification. It appears that firms time their declassification to coincide with strengthened liquidity
ratios: declassifying firms’ current ratios are improving prior to the declassification and the
declassification smoothes liquidity measures in a time-series sense.
8
Leverage is increasing prior to declassification. Long-term debt ratios are increasing in the year of
declassification even after the short-term obligations are taken out of long-term debt and declassification
smoothes long-term debt ratios toward industry benchmarks.
We also find that reported violations of restrictive current ratio or working capital-based debt
covenants are negatively associated with reclassification. Reclassification may have been successfully
used to avoid violations of such covenants.
Our study provides further evidence of management's tendency to intervene in the financial reporting
process but more study is required to understand the underlying motivations for such intervention. We do
not know why firms reclassify debt, but they do engage in this behavior, it is not random, and the dollar
amounts are substantial. The use of reclassification does not preclude other forms of balance sheet or
income statement management. In this vein, further research is needed to understand the interplay
between reclassification and other management techniques, including accrual manipulation and
accounting policy shifts. Future research might also address issues such as why managers are motivated to
reclassify, what other forms of financial statement management substitute or complement reclassification,
how users perceive the reclassification and whether those perceptions have economic impact on equity
prices and or bond ratings.
9
REFERENCES
AMIR, E., AND A. ZIV. “Recognition, Disclosure, or Delay: Timing the Adoption of SFAS No. 106.”
Journal of Accounting Research. (Spring 1997): 61-81.
CLEMENT, M., “Analyst Forecast Accuracy: Do Ability, Resources, and Portfolio Complexity Matter?”
Journal of Accounting and Economics. (forthcoming).
DUKE, J.C., AND H.G. HUNT. “An Empirical Examination of Debt Covenant Restrictions and
Accounting-Related Debt Proxies.” Journal of Accounting and Economics. (January 1990): 45-63.
FINANCIAL ACCOUNTING STANDARDS BOARD. “Statement of Financial Accounting Standards
No. 6: Classification of Short-term obligations Expected to be Refinanced.” (1975).
HEALY, P. “The Effects of Bonus Schemes on Accounting Decisions.” Journal of Accounting and
Economics. (April 1985): 85-107.
HOPKINS, P.E. “The Effect of Financial Statement Classification of Hybrid Financial Instruments on
Financial Analysts' Stock Price Judgments.” Journal of Accounting Research. (Supplement 1996):
33-50.
IMHOFF, E., AND J.K. THOMAS. “Economic Consequences of Accounting Standards: The Lease
Disclosure Rule Change.” Journal of Accounting and Economics. (December 1988): 277-310.
JONES, J.J. “Earnings Management During Import Relief Investigations.” Journal of Accounting
Research. (Autumn 1991): 193-228.
LEV, B. “Industry Averages as Targets for Financial Ratios.” Journal of Accounting Research. (Autumn
1969): 290-299.
MOHR, R.M. “Unconsolidated Finance Subsidiaries: Characteristics and Debt/Equity Effects.”
Accounting Horizons. (March 1988): 27-34.
PRESS, E.G. AND J. WEINTROP “Accounting-based constraints in public and private debt agreements:
Their association with leverage and impact on accounting choice.” Journal of Accounting and
Economics. (1990): 65-95.
SCHIPPER, K. “Commentary on Earnings Management.” Accounting Horizons. (1989) 91-102.
WATTS, R.L. AND J.L. ZIMMERMAN. “Positive Accounting Theory: A Ten Year Perspective.” The
Accounting Review. (January 1990): 131-156.
WEISS, I. “Earnings Management in Response to an Exogenous Non-Recurring Item.” Working paper,
University of Chicago, 1999.
10
Exhibit 1
Except from a 10K Financial Statement Footnote
That Reports Declassification of Amounts Previously Reclassified
H J HEINZ COMPANY APR 29, 1992
6. Long-Term Debt
Range of
Interest
Maturity
(Fiscal Year)
Commercial paper Variable
Eurodollar bonds
7½%
Revenue bonds
4 - 11¾%
Promissory notes 6½ - 12%
Other
7¼ - 8¾%
1992
1997
1993-2016
1993-2003
1993-1998
1992
1991
75,000
34,584
31,085
9,231
149,900
$ 437,696
75,000
67,428
24,188
6,889
611,201
144,258
294,158
115,770
$ 178,388
234,329
845,530
128,593
$ 716,937
United States dollars:
(in thousands)
$
Foreign Currencies
Total long-term debt
Less portion due within one year
In 1992, the company modified its domestic commercial paper backup credit lines. At year-end
1992, such credit lines totaled $ 1,180 million and expire nine to twelve months after year-end
unless otherwise extended. At the end of 1991, such credit lines totaled $ 590 million and were
cancellable only after 390 days written notice. The effect of the modification to the credit lines is
that commercial paper supported by such credit lines, which was classified as long-term debt at
year-end 1991, is now classified as short-term debt. Consequently, as of April 29, 1992, the
company had $1,064.2 million of domestic commercial paper classified as short-term debt,
whereas, as of May 1, 1991, the company had $ 437.7 million of domestic commercial paper
classified as long-term debt.
11
Figure 1
Effects of Reclassification and Declassification on Mean Current Ratios
Panel A: Effect of initial reclassification on mean current ratio reported across time for 128 firms
that reclassified in the current year and did not reclassify in the three prior years.
2.0
Effect of SFAS 6
adjustment
1.5
Current ratio
1.0
Current ratio before
SFAS 6 adjustment
0.5
0.0
Three years
prior
Two years
prior
Prior year
Current year
0
0
0
0.30
1.63
1.62
1.52
1.20
Effect of SFAS 6
adjustment
Current ratio before SFAS
6 adjustment
Panel B: Effect of declassification on mean current ratio reported across time for 47 firms that
declassified in the current year and reclassified in the three prior years.
2.0
Current ratio
1.5
Effect of SFAS 6
adjustment
1.0
Current ratio before
SFAS 6 adjustment
0.5
0.0
Three years
prior
Two years
prior
Prior year
Current year
Effect of SFAS 6
adjustment
0.47
0.43
0.32
0
Current ratio before
SFAS 6 adjustment
1.20
1.11
1.21
1.47
12
Table 1
Univariate Tests of Reclassification Effect on Balance Sheet Ratios
Panel A - Current Ratio Tests
(1)
(2)
(3)
(4)
Effects of Reclassification on Current Ratio,
Year-to-Year Changes in Reported and Adjusted Current Ratios,
Differences in Current Ratios Between Reclassification Firms and Industry Benchmarks, and
Differences in Year-to-Year Changes in Current Ratios Between Reclassification Firms and Industry Benchmarks
Test:
——————(1)——————
————(2)————
—————(3)—————
Difference in Current
Initial-Year Reclassification Firms
Year
N
1985
22
1986
19
Reported Adjusted
Current Current
b
c
Ratio
Ratio
1.75
1.41
1.34
1.09
Reclass
d
Effect
***
0.41
***
0.32
-0.02
-0.35
***
-0.14
**
0.23
1.54
1.29
0.25
1988
13
1.50
1.25
0.25
1989
18
1.65
1.26
0.39
**
Change
from
Previous
Year in
Adjusted
Current
f
Ratio
***
-0.43
*
-0.67
Reclass
Firms’
Reported
And
Industry
gh
Benchmark
0.05
-0.18
Current Ratio Between:
Reclass
Firms’
Adjusted
And
Industry
gi
Benchmark
**
-0.37
-0.01
Reclass
Firms’
Adjusted
And
Industry
gk
Benchmark
***
-0.43
***
-0.29
-0.61
***
-0.01
-0.27
**
-0.02
-0.26
**
*
-0.50
***
-0.15
-0.42
-0.39
***
-0.20
-0.45
-0.16
0.04
-0.31
-0.32
Reclass
Firms’
Reported
And
Industry
gj
Benchmark
*
**
**
0.24
-0.12
**
0.11
-0.31
0.20
-0.20
0.12
-0.26
**
0.00
-0.22
1990
18
1.67
1.25
0.42
1991
10
1.50
1.29
0.22
**
-0.16
0.11
-0.13
0.12
-0.21
0.00
-0.34
**
-0.17
-0.36
**
0.02
-0.17
*
0.23
-0.01
***
0.02
-0.30
***
0.02
-0.19
-0.29
***
-0.03
-0.22
1.57
1.24
0.33
1993
13
1.30
1.11
0.19
1.37
1.13
0.24
1985-94 149
1.56
1.23
0.32
medians
1.36
1.11
0.24
*
**
0.09
0.04
16
*
*
***
1992
5
Change
from
Previous
Year in
Reported
Current
e
Ratio
-0.07
15
Differences in Changes of
Ratios Between:
***
1987
1994
a
————— (4) —————
0.21
-0.03
-0.09
-0.32
***
-0.02
-0.34
***
-0.02
-0.34
***
-0.03
-0.24
***
-0.09
**
-0.32
**
*
***
***
Means are reported for each year. Both means and medians are reported for the overall sample period.
* **
***
, , and denote statistically significant differences from zero at the .05, .01, and .001 levels, respectively (two-tailed t-test for means
and Wilcoxon sign-rank test for medians).
(See notes following Panel B of this table.)
13
Table 1 Continued
Univariate Tests of Reclassification Effect on Balance Sheet Ratios
Panel B - Long-Term (LT) Debt Ratio Tests
(1)
(2)
(3)
(4)
Effects of Reclassification on Long-Term Debt Ratios,
Year-to-Year Changes in Reported and Adjusted Long-Term Debt Ratios,
Differences in Long-Term Debt Ratios Between Reclassification Firms and Industry Benchmarks, and
Differences in Year-to-Year Changes in Long-Term Debt Ratios Between Reclassification Firms and Industry Benchmarks
Test:
——————(1)——————
————(2)————
—————(3)—————
————— (4) —————
Difference in Long-Term
Initial-Year Reclassification Firms
Reported Adjusted
LT Debt LT Debt
b
c
Ratio
Ratio
Reclass
d
Effect
Year
N
1985
22
0.22
0.14
0.08
1986
19
0.30
0.23
0.07
0.07
**
-0.00
*
-0.01
*
-0.02
*
-0.01
**
0.04
-0.02
0.04
***
0.07
**
0.08
0.01
0.04
-0.03
0.06
0.05
-0.02
0.03
-0.03
0.09
-0.03
**
0.03
-0.02
0.02
-0.03
0.03
-0.03
**
0.03
-0.03
0.01
-0.06
***
0.01
-0.02
-0.02
-0.06
0.06
16
0.21
0.14
0.07
1993
13
0.20
0.16
0.04
0.23
0.18
0.06
0.25
0.18
0.06
***
***
0.05
**
***
***
1992
0.18
-0.01
*
-0.04
-0.06
0.05
0.23
*
Reclass
Firms’
Adjusted
And
Industry
gk
Benchmark
**
0.04
0.17
medians
0.05
-0.00
0.22
1985-94 149
-0.04
0.00
10
5
0.06
*
-0.01
1991
1994
0.01
**
*
Reclass
Firms’
Reported
And
Industry
gj
Benchmark
0.05
0.06
0.18
**
Reclass
Firms’
Adjusted
And
Industry
gi
Benchmark
0.05
0.05
0.20
0.24
0.04
LT Debt Ratio Between:
**
0.19
0.26
18
-0.02
0.08
0.24
1990
**
Difference in Changes of
**
13
0.22
Reclass
Firms’
Reported
And
Industry
gh
Benchmark
***
15
0.29
Debt Ratios Between:
Change
from
Previous
Year in
Adjusted
LT Debt
f
Ratio
0.06
1988
18
Change
from
Previous
Year in
Reported
LT Debt
e
Ratio
***
1987
1989
a
**
0.05
***
0.05
***
0.04
**
-0.01
*
-0.01
***
-0.02
0.03
***
0.03
**
0.01
*
0.05
**
0.03
-0.03
***
-0.04
***
-0.04
*
**
-0.03
*
-0.01
*
-0.01
***
-0.01
***
-0.02
0.05
0.05
0.03
*
***
Means are reported for each year. Both means and medians are reported for the overall sample period.
* **
***
, , and denote statistically significant differences from zero at the .05, .01, and .001 levels, respectively (two-tailed t-test for means
and Wilcoxon sign-rank test for medians).
a
Reclassification firm years occur when a firm reclassifies short-term obligations to long-term in the current year but does not do so in
the previous year.
b
Current (long-term debt) ratio is the ratio of current assets to current liabilities (long-term debt to total assets).
c
Adjusted current (long-term debt) ratio is reported current (long-term debt) ratio, without the effect of reclassification of short-term
obligations to long-term.
d
Reported current (long-term debt) ratio less adjusted current (long-term debt) ratio.
e
Reported current (long-term debt) ratio for the current year, less reported current (long-term debt) ratio for the previous year.
f
Adjusted current (long-term debt) ratio for the current year, less adjusted current (long-term debt) ratio for the previous year.
g
Industry benchmarks are the median current (long-term debt) ratios of the firms in the respective two-digit SIC industry classification.
h
Reclassification firms’ reported current (long-term debt) ratio, less the respective reported industry benchmark current (long-term debt)
ratio.
i
Reclassification firms’ adjusted current (long-term debt) ratio, less the respective reported industry benchmark current
(long-term debt) ratio.
j
Reclassification firms’ change from previous year’s reported current (long-term debt) ratio, less the respective change in reported industry
benchmark current (long-term debt) ratio.
k
Reclassification firms’ change from previous year’s adjusted current (long-term debt) ratio, less the respective change in reported
industry benchmark current (long-term debt) ratio.
14
Table 2
Univariate Tests of Declassification Effect on Balance Sheet Ratios
Panel A - Current Ratio Tests
(1)
(2)
(3)
Effect of Current-Year Declassification on the Year-to-Year Change in Current Ratio,
Differences in Current Ratios Between Declassification Firms and Industry Benchmarks, and
Differences in Year-to-Year Changes in Current Ratios Between Declassification Firms and Industry
Benchmarks
(1)
Test:
Declassification Firms
Change
from
Previous
Year in
Reported
Reported
Current
Current
b
c
Ratio
Ratio
(2)
Differences in
Current Ratios
Between:
a
Change
From
Previous
Year in
Adjusted
Current
d
Ratio
Year
N
1985
14
1.81
0.12
0.48
1986
9
1.84
0.27
0.66
Declass
Firms’
Reported
And
Industry
ef
Benchmark
(3)
Differences in Changes of
Current Ratios Between:
Declass
Firms’
Reported
And
Industry
eg
Benchmark
Declass
Firms’
Adjusted
And
Industry
eh
Benchmark
**
-0.07
0.12
0.47
*
0.20
0.25
0.60
*
**
*
*
1987
12
1.60
-0.08
0.22
-0.20
-0.03
0.25
1988
13
1.43
0.00
0.25
-0.11
0.07
0.31
1989
11
1.76
-0.12
0.31
-0.09
0.06
0.47
1990
11
1.37
-0.32
-0.10
-0.20
-0.23
-0.02
-0.02
0.20
*
*
***
**
**
***
1991
18
1.41
-0.03
0.20
-0.19
1992
13
1.26
-0.27
0.05
-0.25
-0.38
-0.04
*
-0.13
-0.02
0.26
*
-0.12
0.05
0.25
***
-0.11
**
-0.12
1993
12
1.50
0.06
0.38
1994
11
1.56
0.02
0.25
1985-94 124
1.54
1.37
-0.03
-0.02
medians
*
**
0.26
***
0.21
*
-0.01
-0.01
*
*
***
0.27
***
0.21
Means are reported for each year. Both means and medians are reported for the overall sample period.
* **
***
, , and denote statistically significant differences from zero at the .05, .01, and .001 levels, respectively (two-tailed t-test for
means and Wilcoxon sign-rank test for medians).
(See notes following Panel B of this table.)
15
Table 2 Continued
Univariate Tests of Declassification Effect on Balance Sheet Ratios
Panel B - Long-Term Debt Ratio Tests
(1) Effect of Current-Year Declassification on the Year-to-Year Change in Long-Term Debt Ratio,
(2) Differences in Long-Term Debt Ratios Between Declassification Firms and Industry Benchmarks, and
(3) Differences in Year-to-Year Changes in Long-Term Debt Ratios for Declassification Firms and for
Industry Benchmarks
(1)
Test:
 (2) 
Differences in
Long-Term
Debt Ratios
Between:
a
Year
Initial-Year Declassification Firms
Change
Change
from
From
Previous
Previous
Reported
Year in
Year’s
Long-Term Reported
Adjusted
Debt
L-T Debt
L-T Debt
b
c
d
N
Ratio
Ratio
Ratio
1985
14
1986
1987
9
12
0.19
0.24
0.20
*
-0.03
0.00
*
-0.04
*
Declass
Firms’
Reported
And
Industry
ef
Benchmark
0.03
0.02
*
0.07
0.02
0.01
-0.04
(3)
Differences in Changes
of Long-Term Debt
Ratios Between:
Declass
Firms’
Reported
And
Industry
eg
Benchmark
Declass
Firms’
Adjusted
And
Industry
eh
Benchmark
*
0.01
*
0.03
*
-0.02
-0.05
-0.04
-0.06
1988
13
0.20
-0.02
0.02
0.10
0.10
0.15
1989
11
0.25
-0.04
0.02
0.01
-0.02
0.04
1990
11
0.24
0.00
0.04
*
0.04
0.00
0.04
1991
18
0.21
-0.03
*
-0.01
-0.03
0.03
*
*
-0.01
-0.07
-0.06
*
0.06
0.04
-0.03
0.03
*
-0.01
0.02
-0.02
0.01
0.01
0.00
-0.02
***
-0.03
0.03
***
0.02
1992
13
0.16
-0.06
1993
12
0.21
-0.04
1994
11
0.21
-0.04
1985-94 124
0.21
0.21
-0.03
***
-0.02
medians
0.03
***
*
***
0.03
***
0.02
***
*
*
-0.01
**
Means are reported for each year. Both means and medians are reported for the overall sample period.
* **
***
, , and denote statistically significant differences from zero at the .05, .01, and .001 levels, respectively (two-tailed t-test for
means and Wilcoxon sign-rank test for medians).
a
Declassification firm-years occur when a firm reclassifies short-term obligations to long-term in the previous year but does not do
so in the current year.
b
Current (long-term debt) ratio is the ratio of current assets to current liabilities (long-term debt to total assets).
c
Mean reported current (long-term debt) ratio for the current year, less mean reported current (long-term debt) ratio for the previous
year.
d
Mean reported current (long-term debt) ratio for the current year, less mean reported “adjusted” current (long-term debt) ratio for
the previous year. (Adjusted current and long-term debt ratios for the previous year are computed without the effect of that year’s
reclassification of short-term obligations to long-term.)
e
Industry benchmarks are the median current (long-term debt) ratios of the firms in the respective two-digit SIC industry
classification.
f
Declassification firms’ reported current (long-term debt) ratio, less the respective reported industry benchmark current (long-term
debt) ratio.
g
Declassification firms’ change from previous year’s reported current (long-term debt) ratio, less the respective change in reported
industry benchmark current (long-term debt) ratio.
h
Declassification firms’ change from previous year’s adjusted current (long-term debt) ratio, less the respective change in reported
industry benchmark current (long-term debt) ratio.
16
1
Based on discussions with auditors and CFOs, we assume that firms have considerable freedom when choosing to
reclassify and declassify; i.e., they can elect to either pass or fail the ability requirements, and their expressed intent
is hard to contest.
2
For discussion purposes, we define liquidity measures as relating to current assets and current liabilities either as a
ratio or as a difference. We use the term leverage to mean the ratio of long-term debt to total assets.
3
For example, see Healy [1985], Jones [1991], Schrand and Walther [1997], and Weiss [1999]. For reviews, see
Schipper [1989] and Watts and Zimmerman [1990].
4
Prior research has shown that firms seek to keep long-term debt off the balance sheet, either because it affects
financial statement users’ perceptions of how risky the firm is or because contractual obligations are specified in
terms of book leverage; for example, Amir and Ziv [1997] consider SFAS 106 OPEB obligations, Imhoff and
Thomas [1988] consider capitalization of leases, and Mohr [1988] considers consolidation of finance subsidiaries.
5
As noted later, our test sample was matched with a control sample on the basis of both firm size and industry
membership.
6
Recent empirical evidence shows that balance sheet classifications within the debt section can have real effects on
financial analysis and valuation judgments (Hopkins [1996]).
7
Total assets average $5.1 billion for reclassifying firm-years versus $3.8 billion for non-reclassifying firm-years,
the mean ratio of debt-to-total assets is 0.27 for reclassifiers and 0.22 for non-reclassifiers, and current ratio averages
1.46 for reclassifiers and 1.59 for non-reclassifiers. Complete descriptive statistics for the sample are available from
the authors.
8
Figure1, Panel A (Panel B) represents the three-year pattern in current ratios for firms that reclassify (declassify) in
the current year and that also did not (did) reclassify in the prior three years. Because of the requirement for three
consecutive years of non-reclassification (reclassification), Figure 1 reflects fewer observations than in the
subsequent Tables.
9
Annual statistics are reported to demonstrate that both reclassification and declassification effects are relatively
evenly distributed across the entire sample period, and that in each case the directions of the differences are the same
as the overall sample differences. Medians are reported in order to demonstrate that the mean effects are not driven
by outliers;. exceptions are noted when they occur.
10
Current ratios are generally larger than long-term debt ratios. Consequently, reclassification appears to have a
larger impact on the current ratio than on the long-term debt ratio. In other words, one should not compare the
magnitudes of the current ratio effects of reclassification and declassification with the size of long-term debt ratio
effects.
17