Journal of Accounting Research
Vol. 39 No. 2 September 2001
Printed in U.S.A.
Balance Sheet Management: The
Case of Short-Term Obligations
Reclassified as Long-Term Debt
J E F F R E Y D . G R A M L I C H ,∗ M A R Y L E A M C A N A L L Y , †
AND JACOB THOMAS‡
Received 24 November 1998; accepted 22 March 2000
ABSTRACT
We investigate potential management of balance sheet ratios by a sample of
firms that reclassify short-term obligations to long-term debt and subsequently
declassify that debt (return it to the current liability section). Although aggregate measures of liabilities and equity remain unchanged when firms reclassify
(declassify), the practice does increase (decrease) reported measures of liquidity, such as the current ratio, and long-term leverage. Our results suggest
that firms reclassify and declassify to smooth reported liquidity and leverage,
relative to the prior year and to industry benchmarks. Our evidence is also
consistent with firms working around restrictive debt covenants.
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
∗ University of Hawaii at Manoa; †University of Texas at Austin; ‡Columbia University. This
paper grew out of a class presentation by Tom Wellman, Controller of Alexander & Baldwin,
Inc. 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, University of Oklahoma, Texas A&M University, and Copenhagen Business
School.
283
C , University of Chicago on behalf of the Institute of Professional Accounting, 2001
Copyright 284
J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
when they are returned to the current liability section of the balance sheet.
(We define “reclassification” as the practice of including some short-term
obligations in the long-term liability section of the balance sheet. We define
“declassification” as the practice of reversing a prior reclassification.) 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
management states its intent to roll over such obligations on a long-term
basis and can demonstrate its ability to do so. A firm can demonstrate that
ability by securing a non-cancelable bank loan commitment that extends
beyond the following fiscal year-end.1
Reclassification has no impact on aggregate measures of assets, liabilities,
or equity, although it increases both reported liquidity and reported longterm leverage. While considerable research has examined why and how
firms manage their income statements,2 much less attention has been paid
to balance sheet management.3 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.
We examine a sample of firms that reclassify short-term obligations to longterm and also declassify some of that debt between 1984 and 1994. We find
that underlying current ratios before the effects of reclassification were substantially lower (higher) in the initial year of reclassification (declassification)
than the prior year and industry benchmarks. However, the act of reclassifying/declassifying causes reported current ratios to be smoothed back
toward levels reported in prior years and toward industry benchmarks. Similar, but weaker, patterns of decreases (increases) in underlying long-term
debt ratios are also observed in the initial year of reclassification (declassification). Again, the act of reclassifying (declassifying) short-term debt causes
reported long-term debt ratios to move in the opposite direction. Since the
underlying changes in long-term debt ratios are not as large as those for current ratios, the impact of reclassification and declassification on reported
long-term debt ratios more than compensates for the underlying changes.
Additionally, we document 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. Reported covenant violations
are less frequent among reclassifying firms than among other firms in the
sample.
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 difficult to contest.
2 For example, see Healy [1985], Jones [1991], Schrand and Walther [2000], and Weiss
[1999].
3 Prior research shows 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.
BALANCE SHEET MANAGEMENT
285
We propose two explanations for our results. First, firms that reclassify are
trying to meet inter-temporal and/or cross-sectional liquidity and leverage
targets. In an environment characterized by information asymmetry and
exogenous shocks to fundamental liquidity, a firm may choose to manage
its reported level of liquidity to avoid reporting lows or highs that could be
misconstrued by external constituents.4
Second, reclassifying firms may be close to violating debt covenants denominated in terms of reported liquidity ratios (see Duke and Hunt [1990]
and Press and Weintrop [1990] for examples). Reclassification allows firms
to move a critical ratio, thereby avoiding costly renegotiations or debt default. Our conversations with audit partners reveal 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 identify 211 firms that appear to reclassify short-term debt during the 1984 to 1994 period.5 If closer examination
reveals that a firm reclassifies short-term debt as long-term at any point during the 11-year window, we collect short and long-term debt footnotes for
the entire period. We gather financial statement information from Compustat to compute measures of liquidity, leverage, and profitability. Our final
sample contains 197 firms, representing 1765 firm-years.
We read debt footnotes for this sample and code information obtained
on reclassification. We also search for the terms associated with supporting
loan commitments or lines of credit and debt covenant information, as well
as violations thereof. A firm-year is a reclassification if commercial paper,
notes, or other items of debt maturing within the following year are classified
as long-term pursuant to the “intent and ability”paragraph of SFAS 6. We
code a firm-year as a declassification if the firm ceases reclassification of all
amounts during the year. Interestingly, most declassifying firms continue
to use short-term 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 a declassification
disclosure taken from a Form 10 K.
4
There is some evidence that shows that balance sheet classifications within the debt section
can have real effects on financial analysis and valuation judgments (Hopkins [1996]).
5 The following search term was applied to the AR group file within the NAARS library of
Lexis/Nexis: ((DATE = 1984) AND (COMMERCIAL PAPER W/200 (CLASSIF! W/25 (LONGTERM OR NONCURRENT)) AND (COMMERCIAL PAPER W/200 (DUE W/10 1985)))). For
1984, this search generates 34 firms. The search term is modified accordingly for each of the
subsequent 10 years. Combining the results of these 11 searches, this process produces 462
firm-years and 211 different firms. Further examination eliminates 14 firms for which (1)
footnotes do not indicate debt reclassification, or (2) financial data cannot be obtained from
Compustat or other sources. The final sample contains only firms that reclassify short-term
debt as long-term at some point during the 1984 to 1994 period and report sufficient financial
data for the analyses.
286
J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
EXHIBIT 1
Excerpt from a 10-K Financial Statement Footnote That Reports Declassification
of Amounts Previously Reclassified
H J HEINZ COMPANY APR 29, 1992
6. Long-Term Debt
United States dollars: (in thousands)
Commercial paper
Eurodollar bonds
Revenue bonds
Promissory notes
Other
Foreign Currencies
Total long-term debt
Less portion due within one year
Range of
Interest
Maturity
(Fiscal Year)
Variable
7 12 %
4–11 34 %
6 12 –12%
7 14 –8 34 %
1992
1997
1993–2016
1993–2003
1993–1998
1992
1991
$–
75,000
34,584
31,085
9,231
149,900
144,258
294,158
115,770
$178,388
$437,696
75,000
67,428
24,188
6,889
611,201
234,329
845,530
128,593
$716, 937
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 cancelable 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.
Using Compustat data, we calculate annual industry benchmarks for liquidity and leverage measures. Each firm’s benchmark is the prior year’s
median ratio for a control group of firms from the same total asset quartile
within the same 2-digit SIC group.
3. Empirical Findings
Over the 1984–1994 sample period, half the firm-years have short-term
obligations reclassified as long-term debt, and reclassification lasts five years
on average. The size of reclassified liabilities is substantial when firms 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, firms are on average larger, more leveraged,
less liquid, and more profitable than sample firms in non-reclassifying
years.6
6 Total assets average $5.1 billion for reclassifying firm-years versus $3.8 billion for nonreclassifying 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.
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FIG. 1.—Reported and adjusted current ratio for the initial and three prior years for 128
cases where short-term debt is reclassified as long-term. The sample is identified from the
NAARS library of Lexis/Nexis, and covers the period between 1984 and 1994. The figure
shows how firms masked a decline in the underlying or adjusted current ratio in the year of
initial reclassification (current year) by reclassifying short-term debt as long-term (noted as the
effect of SFAS 6 adjustment). As a result, they reported a higher current ratio than they would
have otherwise.
3.1
UNIVARIATE COMPARISON AGAINST PRIOR YEARS
Figures 1 and 2 show the sample mean current ratio with and without the
effects of SFAS 6 reclassification.7 Absent the decision to reclassify, initial
reclassifiers (figure 1) would experience a substantial decline in current
ratio. Before the reclassification effect, the mean current ratio falls from
1.52 in the prior year to 1.20 in the initial reclassification year. Reclassifying
firms are able to substantially reverse this decline and report a mean current
ratio of 1.50 by reclassifying short-term debt as long-term. Examination of
current ratios for the two earlier years suggests that the decline does not
occur suddenly, since evidence of the decline is apparent in the prior year
as well.
In contrast, current ratios for declassifiers (without considering the effect of reclassification) strengthen considerably in the year of declassification (figure 2). Without reclassification, mean current ratios prior to declassification would be 1.20, 1.11, and 1.21 in the three years preceding
declassification (see bottom row of figure 2), but the mean ratios increase
to 1.67, 1.54, and 1.53, respectively, with reclassification of short-term debt.
If these firms had continued to reclassify in the year of declassification,
7 Figure 1 (2) represents the three-year pattern in current rations 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),
the figures reflect fewer observations than in the corresponding tables.
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J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
FIG. 2.—Reported and adjusted current ratio for the initial and three prior years for 47
cases of declassification, where short-term debt which was previously reclassified as long-term
is returned to the current liabilities section of the balance sheet. The sample is identified from
the NAARS library of Lexis/Nexis, and covers the period between 1984 and 1994. These firms
had been reporting a higher current ratio than the underlying or adjusted current ratio in
the three prior years by reclassifying short-term debt as long-term (noted as effect of SFAS 6
adjustment). The figure shows how firms masked an increase in the underlying current ratio
in the year of declassification (current year) by declassifying the short-term debt that had
previously been reclassified as long-term. As a result, they reported a lower current ratio than
they would have otherwise.
reported current ratios would have increased substantially, since the underlying (before reclassification) current ratio increases from 1.21 to 1.47.
Firms apparently halt reclassification to avoid reporting such an increase. As
a result, the reported current ratio remains relatively smooth (decreasing
slightly from 1.53 to 1.47). The results in both figures suggest that firms
strategically reclassify and declassify short-term debt when current assets
and/or current liabilities change substantially, and these actions mitigate
changes in reported current ratios.
Tables 1 and 2 present statistics on the impact of reclassification and declassification on current and long-term debt ratios, for the initial year of
reclassification and declassification.8 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 that portray the firm’s
fundamental position, by returning the reclassified amounts to the current
liabilities section. The tables provide the mean and median values of these
ratios, as well as the associated levels of statistical significance when making
comparisons over time and with industry benchmarks.
8 Annual statistics (not reported here) 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.
TABLE 1
Univariate Tests of Reported and Adjusted Mean Current Ratios for the First Year of Reclassification by Firms that Reclassify Short-term Debt as Long-term,
Between 1984 and 1994.a The sample was identified from the NAARS library of Lexis/Nexis. The tests are designed to identify whether the reclassification
decision moved reported current and long-term debt ratios towards those for the prior year and/or towards size-adjusted industry benchmarks
Tests : 1) Effects of reclassification on reported and adjusted ratios, 2) Year-to-year changes in reported and adjusted ratios, 3) Comparisons of
industry benchmark ratios to reclassification firms’ ratios, and 4) Comparisons of year-to-year changes in industry benchmark ratios to
year-to-year changes in reclassification firms’ ratios
Test 1
Test 2
Test 3
Test 4
Reclass.
Effectd
Change in Firm:
Reported
Adjusted
Ratioe
Ratiof
Panel A: Current ratio tests
Mean
151
1.56
Median
151
1.36
1.23
1.11
0.32***
0.24***
−0.02
−0.03
−0.02
−0.09**
Panel B: Long-term debt ratio tests
Mean
149
0.25
Median
149
0.23
0.18
0.18
0.06***
0.05***
Statistic
#of FirmYears
Reported
Ratiob
0.05***
0.04***
−0.34***
−0.24***
−0.01*
−0.02***
0.03***
0.01**
Change in Industry
Benchmarkg
Versus Change in Firm:
Reported
Adjusted
Ratioj
Ratiok
−0.34***
−0.32***
0.02
0.02
−0.30***
−0.19***
−0.04***
−0.04***
0.05***
0.03***
−0.01
−0.02***
289
Notes: *, **, 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. Sample
comprises 120 firms and 149 firm-years.
b
Reported current (long-term debt) ratio is the ratio of current assets to current liabilities (long-term debt to total assets) as reported on the balance sheet.
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 reported current (long-term debt) ratio for the previous year. (Adjusted current and long-term
debt ratios for the previous year cannot be computed because there is no reclassification of short-term obligations to long-term in the previous period for initial
reclassification firm-years.)
g
Industry benchmark is the previous year’s median current (long-term debt) ratio of all Compustat firms in the same total asset quartile within the same two-digit
SIC group as the reclassification firm.
h
Reclassification firms’ reported current (long-term debt) ratio, less the respective industry benchmark current (long-term debt) ratio.
i
Reclassification firms’ adjusted current (long-term debt) ratio, less the respective industry benchmark current (long-term debt) ratio.
j
Reclassification firms’ change from previous year’s reported current (long-term debt) ratio, less the change in respective industry benchmark current (long-term
debt) ratio.
k
Reclassification firms’ change in adjusted current (long-term debt) ratio from previous year’s reported ratio, less the change in respective industry benchmark
current (long-term debt) ratio.
BALANCE SHEET MANAGEMENT
Adjusted
Ratioc
Industry Benchmarkg
Versus Firm:
Reported
Adjusted
Ratioh
Ratioi
Test 2
Benchmarke
Change in Firm:
Statistic
#of Firm-Years
Reported Ratiob
Panel A: Current ratio tests
Mean
124
1.54
Median
124
1.37
Panel B: Long-term debt ratio tests
Mean
124
0.21
Median
124
0.21
Reported Ratioc
Industry
Versus Firm
Test 3
Change in Industry Benchmarke
Versus Change in Firm:
Adjusted Ratiod
Reported Ratiof
Reported Ratiog
Adjusted Ratioh
−0.03
−0.02
0.26***
0.21***
−0.11**
−0.12**
−0.01
−0.01
0.27***
0.21***
−0.03***
−0.02***
0.03***
0.02***
0.01
0.00
−0.02
−0.03***
0.03**
0.02***
Notes: *, **, 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. Sample comprises
105 firms and 124 firm-years.
b
Reported current (long-term debt) ratio is the ratio of current assets to current liabilities (long-term debt to total assets) as reported on the balance sheet.
c
Reported current (long-term debt) ratio for the current year, less reported current (long-term debt) ratio for the previous year.
d
Reported current (long-term debt) ratio for the current year, less adjusted current (long-term debt) ratio for the previous year. (Adjusted current and long-term
debt ratios for the current year cannot be computed because there is no reclassification of short-term obligations to long-term in the current period for declassification
firm-years.)
e
Industry benchmark is the previous year’s median current (long-term debt) ratio of all Compustat firms in the same total asset quartile within the same two-digit SIC
group as the declassification firm.
f
Declassification firms’ reported current (long-term debt) ratio, less the respective industry benchmark current (long-term debt) ratio.
g
Declassification firms’ change from previous year’s reported current (long-term debt) ratio, less the change in respective industry benchmark current (long-term debt)
ratio.
h
Declassification firms’ change in reported current (long-term debt) ratio from previous year’s adjusted ratio, less the change in respective industry benchmark current
(long-term debt) ratio.
J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
Test 1
290
TABLE 2
Univariate Tests of Declassification Effect on Reported and Adjusted Current and Long-term Ratios for the Year of Declassification by Firms that Reclassify Short-term
Debt as Long-term, Between 1984 and 1994, and Subsequently Declassify (Return that Debt to the Current Liabilities Section).a The sample was identified from the
NAARS library of Lexis/Nexis. The tests are designed to identify whether the declassification decision moved reported current and long-term debt ratios towards those for
the prior year and/or towards size-adjusted industry benchmarks
Tests : 1) Effects of declassification on year-to-year changes in reported and adjusted ratios, 2) Comparisons of industry benchmark ratios to
declassification firms’ ratios, and 3) Comparisons of year-to-year changes in industry benchmark ratios to year-to-year changes in declassification
firms’ ratios
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291
By definition, reclassification increases both the current ratio and the
long-term debt ratio. The mean (median) values of the reclassification effect
reported under “reclass effect” in test 1 of panels A and B of table 1 for the
current and long-term debt ratios are 0.32 (0.24) and 0.06 (0.05), and these
increases are statistically significant (p < .001).9 Since the median results
are generally similar to the mean results for all tests, we do not discuss
them hereafter. Despite the large mechanical increase expected for both the
current and long-term ratio, the reported current ratio decreases slightly in
the initial year of reclassification, when compared to the prior year (mean
of −0.02 in test 2 in panel A). This counterintuitive finding is explained by
the large decline (mean = −0.34) in the adjusted current ratio. Consistent
with the results in figure 1, reclassifiers experience a sharp decline in the
current ratio in the initial reclassification year, and reverse much of that
effect by reclassifying current debt.
The long-term debt ratio results, reported in test 2, panel B of table 1,
suggest that reclassification does not smooth that ratio over time. While
the adjusted long-term debt ratio declines slightly in the initial year (mean
of −0.01, which is significant at the five percent level), the reclassification
causes the reported long-term debt ratio to increase substantially (significant
mean of 0.05). In essence, while reclassifiers experience a sharp decline in
their adjusted current ratio, the decline in the adjusted long-term debt ratio
is more modest. As a result, the reclassification, which almost completely
reverses the effect of the decline in the current ratio, overcompensates for
the decline in the long-term debt ratio.
Similar results are observed for declassifiers (see test 1 in panels A and
B of table 2). While declassification should mechanically decrease reported
current and long-term ratios, the change in reported current ratio is insignificant (mean of −0.03), because declassifying firms experience a substantial
increase in current ratios (mean adjusted current ratio change of 0.26). As
demonstrated in figure 2, declassification effectively smoothes this underlying increase in current ratio. The long-term debt ratios would also have
increased in the year of declassification, had firms continued to reclassify
(significant mean increase of 0.03 in the adjusted ratio). As with reclassification, the effect of declassification is so large that it converts that increase
to a reported decline (significant mean of −0.03).
Overall, if smoothing ratios over time is an objective, both reclassification
and declassification appear to be driven by firms smoothing the current ratio
rather than the long-term debt ratio. However, fundamental decreases (increases) in the long-term debt ratio absorb some of the mechanical increase
(decrease) caused by reclassification (declassification).
9 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.
292
3.2
J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
UNIVARIATE COMPARISON AGAINST INDUSTRY PEERS
The results of test 3 in Table 1, Panel A, suggest that reclassifiers’ fundamental current ratios are considerably lower than industry norms, and
that the firms reclassify to smooth reported ratios toward those norms. The
adjusted current ratios for firms in the initial year of reclassification are considerably lower than the industry benchmark (significant mean difference
of −0.34) but the reported ratios are closer (insignificant mean of −0.02,
significant median of −0.09). Test 4 in table 1, panel A, shows that the difference in adjusted current ratios between reclassifiers and industry norms
arises because current ratios decline sharply during the initial reclassification year (see test 2) for reclassifiers but not for benchmark firms.
A similar comparison of long-term debt ratios to industry benchmarks
(test 3 in table 1, panel B) shows that reclassifying firms are less leveraged
overall than their industry peers in the initial year of reclassification when
adjusted ratios are compared. Because reclassification increases long-term
leverage, however, reported long-term ratios are significantly higher than
industry benchmarks in that year. Test 4 reveals that the adjusted leverage is
lower, at least in part, because the long-term debt ratio declines in the initial
reclassification year.
In sum, the reclassification decision appears to mask a fundamental decline in current ratios by moving reported current ratios toward industry
benchmarks. Although the tests in panel B suggest that fundamental longterm leverage declines at the same time and that reclassification smoothes
reported leverage ratios toward industry benchmarks, the reported leverage
ratios tend to “overshoot” those benchmarks.
Comparisons of declassifiers with their industry peers are reported in
tests 2 and 3 of table 2 (panel A for current ratios and panel B for long-term
debt ratios). While declassification moves current ratios toward industry
benchmarks, considerable differences remain, as evidenced by the large
difference in reported current ratios (mean difference of −0.11 in test 2 of
panel A). The mean difference of −0.01 for test 3 suggests, however, that
the change in reported current ratios for declassifiers is similar to that for
the industry. As noted earlier, declassifiers would have reported a substantial
increase in current ratios if they had not declassified. The large difference
between the change in adjusted current ratios for declassifiers relative to the
industry benchmark (mean difference of 0.27 in test 3 of panel A) suggests
that the fundamental increase in current ratios experienced by declassifiers
is not observed across the industry.
With respect to the long-term debt ratio, recall that declassifiers experience a fundamental increase in their long-term debt ratios in the year of declassification, but the reported long-term debt ratios decline because of the
mechanical effect of declassification. The results reported in test 2 in panel B
of table 2 suggest that the reported long-term leverage for declassifiers is
similar to that of the industry benchmark, in the year of the declassification. And the results reported in test 3 indicate that the change in reported
BALANCE SHEET MANAGEMENT
293
long-term leverage is lower than the industry benchmark (mean of −0.02)
but the change in the adjusted leverage is higher than the industry benchmark (mean of 0.03). Comparison with the results in test 1 suggests that in
the year before declassification, firms’ reported leverage is higher than the
industry benchmark, but the adjusted leverage is lower. Firms experience
a large increase in adjusted leverage in the initial year of declassification,
but a similar increase is not observed for industry benchmark firms. The
act of declassification, however, causes the reported leverage to be similar
to the industry benchmark, which suggests that the declassification decision
could be motivated by a desire to smooth long-term leverage ratios toward
industry norms.
Overall, our evidence of smoothing toward industry benchmarks for firms
that reclassify/declassify is weaker than that for smoothing toward prior
years’ ratios. Also, whereas evidence of time-series smoothing is observed
primarily for current ratios, not for long-term ratios, some evidence of crosssectional smoothing of long-term debt ratios is observed for firms that declassify.
3.3
MULTIVARIATE ANALYSES
To explore what factors jointly affect the reclassification decision, we estimate multivariate logistic regressions.10 Independent variables include 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 its decrease in
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 cross-sectional 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.
Estimated ordinary least squares regressions indicate that the dollar
amount of reclassified short-term obligations is negatively related to
liquidity, leverage, and profitability. Tests of both the time-series and the
cross-sectional smoothing models produce largely similar results. Measures
of R2 range from 25 to 35 percent and the coefficients of interest are highly
10 Results described in this and the following section are not reported in detail. Results are
available from the authors.
294
J . D . GRAMLICH , M . L . M c ANALLY , AND J . THOMAS
significant. Firms appear to make considered choices in both deciding
whether to reclassify and determining the dollar amount to reclassify.
3.4
DEBT COVENANTS AND RECLASSIFICATION
Although 36 percent of the firm-years in our sample disclose current ratio
or working capital limits in debt covenants, few of these limits are quantified. Tests of means show that reported and adjusted current ratios of firms
disclosing working capital or current ratio limits in their footnotes are significantly higher than those of firms that do not disclose such limits. Frequency
tables reveal that a higher proportion of these firms reclassifies than is statistically expected. We perform logistic and OLS regressions and include
a dummy variable for the existence of liquidity based constraints. The results indicate that firms with such covenants are significantly more likely to
reclassify (and they reclassify greater dollar amounts) after controlling for
profitability, liquidity, and leverage.
We also include 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 is not significant. However, when the OLS
regressions are re-run on the sub-sample of firms whose footnotes mention
current ratio or working capital covenants, we find a strong negative association between the covenant violation and the amount reclassified. Thus,
firms with footnotes revealing liquidity-based covenants, but not covenant
violations, reclassify more debt than sample firms that do not report such
covenants. One possibility is that these firms effectively use reclassification
to avoid covenant violations.
4. Conclusion
We find that both reclassification and declassification smooth liquidity
and leverage measures reported on the balance sheet. Short-term obligations reclassified as long-term debt smooth liquidity measures in a timeseries and cross-sectional sense. Initial reclassifications are associated with
deteriorating current ratios when compared with the prior year and with 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 fundamental liquidity ratios:
declassifying firms’ current ratios are improving prior to the declassification
and the declassification smoothes liquidity measures in a time-series sense.
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.
BALANCE SHEET MANAGEMENT
295
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 an economic impact on equity
prices and bond ratings.
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