Should Preferred Stock be Classified as a Liability? Evidence from Implied Cost of Common Equity Capital

45 Pages Posted: 13 Sep 2007

See all articles by C.S. Agnes Cheng

C.S. Agnes Cheng

Hong Kong Polytechnic University - School of Accounting and Finance

Cathy Zishang Liu

affiliation not provided to SSRN

Kaye Newberry

University of Houston - Bauer College of Business

Kenneth John Reichelt

Louisiana State University, Baton Rouge - Department of Accounting

Date Written: September 12, 2007

Abstract

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are currently working together towards a comprehensive standard of accounting for financial instruments with characteristics of equity, liability, or both. An important facet of this project is to determine the appropriate liability vs. equity classification of preferred stock. In its preliminary views, the FASB has selected an ownership approach. Recent Board deliberations resulted in a majority vote (with two dissenting board members) for classifying even perpetual preferred stock as a liability under the ownership approach. We contribute to this important question by examining how the equity market, on average, incorporates different forms of preferred stock (and the components of their other liability obligations) into the cost of common equity capital (COCEC). Using a change model for a large sample of firms over the period 1980-2005, we find that COCEC increases with firms' preferred stock holdings. This finding holds whether the increase in preferred stock relates to shares that are redeemable, non-redeemable, or convertible. Our results suggest that a strict liability view of preferred stock is a viable classification scheme.

Keywords: cost of common equity capital

JEL Classification: M41, M44, G12, G32

Suggested Citation

Cheng, C.S. Agnes and Liu, Cathy Zishang and Newberry, Kaye and Reichelt, Kenneth John, Should Preferred Stock be Classified as a Liability? Evidence from Implied Cost of Common Equity Capital (September 12, 2007). Available at SSRN: https://ssrn.com/abstract=1014259 or http://dx.doi.org/10.2139/ssrn.1014259

C.S. Agnes Cheng (Contact Author)

Hong Kong Polytechnic University - School of Accounting and Finance ( email )

M715, Li Ka Shing Tower
Hung Hom, Kowloon, Kowloon
Hong Kong

Cathy Zishang Liu

affiliation not provided to SSRN

Kaye Newberry

University of Houston - Bauer College of Business ( email )

Houston, TX 77204
United States

Kenneth John Reichelt

Louisiana State University, Baton Rouge - Department of Accounting ( email )

2821 Business Education Complex
Baton Rouge, LA 70803
United States
225-578-6233 (Phone)

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