An Alternative Approach to Distinguishing Liabilities from Equity: Internal Capital versus External Capital
43 Pages Posted: 18 Dec 2017 Last revised: 30 Aug 2018
Date Written: July 12, 2018
In response to a longstanding debate within the accounting profession on how to clearly distinguish liabilities from equity, we suggest an alternative liability-equity classification scheme in which capital received from external sources (“external capital”) is classified as liabilities and capital earned and retained from the firm’s internal operations (“internal capital”) is classified as equity. One notable implication of this alternative classification scheme that differs from current financial reporting standards is that capital contributed by shareholders (“stock capital”), like capital contributed by debtholders (“debt capital”), is classified as liabilities rather than equity. We evaluate this alternative classification scheme on its ability to provide information about a firm’s solvency risk, a key component of a firm’s financial condition. We find that the proportional amount of stock capital in a firm’s capital structure, like debt capital, is incrementally positively associated with its solvency risk, which we interpret as evidence that classifying stock capital as liabilities is more informative in assessing a firm’s solvency risk than classifying it as equity.
Keywords: Liabilities Versus Equity, Financial Reporting, Capital Structure
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