An Alternative Approach to Distinguishing Liabilities from Equity: Internal Capital versus External Capital

43 Pages Posted: 18 Dec 2017 Last revised: 30 Aug 2018

See all articles by Mary Hill

Mary Hill

Kennesaw State University

Richard A. Price

University of Oklahoma

George W. Ruch

University of Denver - School of Accountancy

Date Written: July 12, 2018

Abstract

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

Suggested Citation

Hill, Mary and Price, Richard A. and Ruch, George W., An Alternative Approach to Distinguishing Liabilities from Equity: Internal Capital versus External Capital (July 12, 2018). Available at SSRN: https://ssrn.com/abstract=3086824 or http://dx.doi.org/10.2139/ssrn.3086824

Mary Hill

Kennesaw State University ( email )

1000 Chastain Rd
Kennesaw, GA 30144
United States

Richard A. Price

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States
405-325-5759 (Phone)

George W. Ruch (Contact Author)

University of Denver - School of Accountancy ( email )

2101 South University
Boulevard, Suite 355
Denver, CO 80208-8921
United States

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