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

Abstract

The numbers reported in corporate financial statements are attributed particular meanings that have evolved to become 'generally 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 represent 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 constituted 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 event 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 generally 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