Does the order of claims to assets on the balance sheet reflect equity risk?

Abstract

This paper empirically examines whether the order of liability and preferred stock accounts presented on the balance sheet is consistent with how the stock market values their riskiness. This paper measures a firm’s riskiness with idiosyncratic risk and employs the first-difference design to test the relation between idiosyncratic risk and the order of current liabilities, noncurrent liabilities and preferred stock, respectively. Further, the paper tests whether operating liabilities are viewed as riskier than financial liabilities. Finally, the authors partition their sample based on the degree of financial distress and investigate whether the results differ between the two subsamples. The paper finds that current liabilities are viewed as riskier than noncurrent liabilities and preferred stock is viewed as less risky than current and noncurrent liabilities, consistent with the ordering on the balance sheet. Further, the paper finds that operating liabilities are viewed as riskier than financial liabilities. Finally, the authors find that total liabilities and preferred stock (redeemable and convertible classes) are viewed as riskier for distressed firms than for nondistressed firms. The authors thoroughly investigate the riskiness of several classes of claims and document that the classification of liabilities and preferred stock classes is relevant to common stockholders for assessing their associated risk.

Keywords

• market valuation
• liabilities
• preferred stock
• riskiness