What is Equity? New Financial Instruments in the Interstices between the Law, Accounting and Economics

DOIhttp://doi.org/10.1111/j.1468-2230.1991.tb01856.x
Published date01 November 1991
Date01 November 1991
What
is
Equity? New Financial Instruments in the
Interstices between the Law, Accounting and Economics
Peter
F.
Pope
and
Anthony
G.
Puxty*
Introduction
The numbers reported
in
corporate financial statements are attributed particular
nicanings that have evolved
to
become ‘gcnerally accepted,’ perhaps
to
the extent
of having been further legitimised by the development of an underpinning conceptual
framework, as
in
the USA. Whether they have received the support of a formal
conceptual framework
or
not, we can observe pervasive evidence that accounting
numbers are perceived to have sufficient credibility
to
be suitable
to
act as a basis
for economic contracting between corporate entities and related interest groups.
Thus, for example, widespread use is made of accounting numbers
in
debt covenants,
structuring management compensation plans, collective wage negotiations and
in
the calculation
of
corporate tax liabilities. Regulatory bodies also rely heavily on
accounting numbers as controls over regulatees, for example, the regulation of
financial firms’ capital adequacy requirements. The
UK
Stock Exchange also imposes
various constraints on listed firms such as requiring the disclosure
in
the directors’
report of contracts of significance (Class
1
transactions), defined as contracts which
rcpresent
in
value a sum equal
to
one per cent or more of a company’s net assets
for
a
capital transaction. Again accounting numbers,
in
this case the total assets
minus total liabilities or net worth
(ie
the equity
of
a firm), assume a pivotal role.
Apart from regulatory controls of various statutory bodies, companies are
constitutcd
within
the framework
of
company law.
At
one level the law can be thought
of as effectively serving as an alternative, more fundamental, control over the
activities of business enterprises, providing a broad framework of ‘generally
acceptable and unacceptable actions which,
in
the absence of the law, would be
extremely costly and hence inefficient
to
permit or restrict through private
contracting arrangements. Accounting numbers play an important role
in
company
law, not just because their disclosure and audit is usually mandated, but also because
of their function
in
the protection of creditors. Of particular importance are the
definitions of equity, creditors (debt) and distributable reserves.
In
the
UK,
companies
are
in
general restricted to distributing realised profits
(less
accumulated losses)
only. Additional restrictions are imposed on investment companies (that require
assets to
be at least
150%
of liabilities) and on insurance companies. The law of
insolvency also hinges crucially on accounting numbers to define the insolvency
evcnt and hence the situations under which directors face penal sanctions. Elsewhere
creditor protection provisions vary
in
detail but still relate
to
accounting statements.
For example, in the USA the Revised Model Business Corporation Act
1984
permits
distributions as long as a corporation is able
to
pay its debts as they fall due and
as long as its total assets exceed total liabilities, where valuations might be based
on gcnerally accepted accounting principles or fair valuation or some other method
that is reasonable
in
the circumstances. State law adoption of these restrictions on
distributions varies,
with
some states having more restrictions consisting of, for
example, constraints on dividends being paid out
of
retained earnings and other
*Dcpiirtnient
of
Accounting snd Finance, University
of
Struthclyde.
’l’lic ;iuthors
iickiiowlcdgc
thc linanciiil support
of
the Institute
of
Ch:ittcred
Accouiitants in England
and
W;tlcs.
Tlrc
Moclcwr
Ltriv
Rcviov
54:6
Novcmbcr
199
I
0026-796
I
889
balance sheet and solvency tests.’ The key point is that
in
formulating the law
designed
to
protect creditors extensive reliance is placed on accounting constructs
such as assets, liabilities, equity and earnings. For the law to be effective these
constructs should display certain qualities.
US
law tends to refer
to
generally accepted
accounting principles and
in
the
UK
the Companies Acts require that accounts should
give a true and
fair
views2 Reference to these notions implies an assumption that
the accounting constructs should be unambiguous.
In
this paper we argue that two key accounting constructs, namely liabilities and
equity, are becoming increasingly ambiguous concepts. From a fundamental
economic perspective we argue that liabilities and equity claims have many
similarities. However, the law and accounting have tended to emphasise differences
between the two concepts, presumably reflecting their historical origins. We point
out that recent innovations
in
financial engineering, perhaps based on the exploitation
of existing ambiguity
in
accounting concepts, have created even more ambiguity
in
the meaning of the terms equity and liability and that this development represents
a major challenge to both the accounting profession and the law. The discussion
is confined
to
the distinction between equity and long term liabilities, since this
is where the main ambiguities arise.’
The remainder of
the
paper is organised as follows.
In
the second section we
examine some definitions of liabilities and equity and identify reasons
why
the
distinction between debt and equity is
so
important under the existing accounting
and legal framework
within
which firms operate.
In
the third section we examine
the conceptual underpinnings of current legal and accounting treatments of equity
as compared to debt.
In
the fourth section we outline the economic similarities and
differences between the two classes of claims.
In
the
fifth
section we demonstrate
how the ambiguity
in
the two constructs has been increased by recent financial
innovations. Finally, we present our conclusions.
Why be Interested in the Distinction between Liabilities
and Equity?
Some
Definitions
UK
company law has
defacto
distinguished between equity and liabilities, but to
our knowledge neither has been comprehensively defined
in
legislation.J
It
is
necessary therefore to
turn
to accounting theory and to pronouncements by profes-
sional accounting bodies to find formal definitions or understandings of the meanings
of these terms. The
UK
institutional body responsible for establishing financial
accounting standards
is
now the Accounting Standards Board, which has taken over
from, and adopted the pronouncements of, its predecessor, the Accounting Standards
Committee (ASC). Exposure Draft 49 issued by the ASC
(1990)
does not define
equity. However,
it
defines assets and liabilities as follows:
I
2
3
Scc, for cxamplc: Robcrts, Saiiison
and
Dugan ‘Thc Stockholdcrs’ Equity Section:
Foriii
without
Substance?’
Accwritirig
Horizorrs
(Dcccnibcr
1990).
SCC,
for
cxamplc: Companies
Act
1985
s
226(2).
Currcnt liabilitics such
as
tradc crcditors
and
othcr cl~iinis fiilling due within one yciir, arc less
probleniatic, although some
of
the conceptual issues regarding their claims rcliitivc
to
other
interest
groups arc applicablc
to
these claim
also.
Dcspitc thc dcfinitioii in the Cornpanics Act
1985,
s
744
to
which wc rcfcr bclow.
4
890

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