An Empirical Analysis of Risk and Liability Components

Abstract

This paper documents the association between market risk measures and leverage components of a firm’s capital structure over the last four decades. High leverage increases risk to common stockholders; however, the definition of a liability reported on the balance sheet has been the subject of debate in recent years. Motivated by the ongoing joint project between the IASB and the FASB on defining equity and liability and an inconclusive decision on the definition of preferred stock, this paper documents how the market has perceived various liability components, (i.e., as debt or equity), including preferred stock, on the right-hand side of the balance sheet. We find that common shareholders perceive higher proportions of preferred stock to assets as risky. In addition to debt, we also find our model works for capital leases and deferred taxes: we confirm that the market perceives higher proportions of capital leases as risky and deferred taxes as equity-like. To facilitate standards setting, it is important to document the views from market participants (Barth et al. 2001). Our study has important implications for the classification of financial instruments with components of debt and equity.

Keywords: Leverage Components, Preferred Stock, Risk Measures

JEL Classification: M41