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In the domain of finance, capital structure relates to how a company funds its assets through some mix of preferred stock, equity, debt, or hybrid securities. It is the combination of sources of finance a firm makes use of in the form of debt, preferred stock or common stock, etc. A corporation’s capital structure is, essentially, the framework or ‘structure’ in which liabilities are put together. However, there is a substantial debate whether preferred stock should be recognized as a liability or should be considered equity.
In general, liability is defined as the purchasing power of the future that is under the ownership of the present. On the other hand, Equity can be defined as liable capital or capital concerning risk. Thus, it can be easily expressed that from the viewpoint of a company it is always a logical and practical approach for a company to classify its financial instruments as equity rather than a liability. This is because as a liability the entire responsibility of the amount is borne by the company in any given circumstances. But in the case of equity, the risk is equally distributed between the company and the creditors. This way the creditor is converted into a stakeholder of the company where, after holding possession of the equity, the creditor’s payment validation would be linked to the rise and fall of the company.
The key measure of a corporation’s capital structure is the ratio of debt and equity capital used in gathering funds to sustain the corporation’s assets. The capital structure has significant repercussions on stockholder value. In addition, capital structure has an impact on leverage, which, sequentially, influences the projected returns and risks for the possessors and creditors of the business. The financial administrations have to balance their finances and attempt to craft an optimal capital structure that maximizes the value of the firm. Capital Structure is also relevant in a firm’s financial management because it significantly affects the demand sustainability and volatility in addition to cost stability. As a result, evaluating preferred stocks as equity would only prove to be a logical conclusion for a company.
Additionally, under International Financial Reporting Standards (IFRS), preferred stock is often reported as debt with the dividends reported in the income statement as interest expense. Under U.S. GAAP, which is the case only for “mandatorily redeemable” preferred stock, otherwise, it is reported as equity. The recognition criteria of liability can be divided into two categories. One is Current Liabilities that include dues that are to be settled within a year. Current liabilities include short-term obligations, unearned revenue when adjusting entries, taxes, accounts, wages, installments to be paid, and accounts payable. Similarly, Long-term liabilities are those that are not expected to be paid within one year like notes payables, long-term product warranties, long-term bonds, pension obligations, and long-term leases.
Thus, in a practical market situation, during bankruptcy, a creditor holds possession of the assets of the company whereas the equity holder is to share the fate of the company whereas, during a boom period the company has no problem settling its accounts with the equity holder from its surplus. As a whole, it is an all-win situation for the company. This is enough motivation for a company to classify its preferred stocks as equity rather than a liability.
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