NEGATIVE BOOK EQUITY AND CORPORATE LEVERAGE.

• Author: Kalu, Kenneth

INTRODUCTION

A firm's equity represents the value of the firm to its owners. Negative book value of equity technically indicates that shareholders' equity has been eroded, as the firm's book value of assets is less than the sum of its total liabilities and owners' equity. Given the limited liability rule, which entails that shareholders would not be called upon to make additional contributions beyond their equity should the firm go into bankruptcy, it is difficult to interpret the true meaning and implications of negative book value of equity (Collins, Pincus, & Xie, 1999). However, since the mid-1980s, many firms in the United States are increasingly reporting negative equity (Brown, Lajbcygier, & Li, 2008; Jan & Ou, 2012). Despite the increasing occurrence of negative book equity (NBE), the most common reactions from accounting and finance scholars have been to ignore such firms in asset pricing modelling (Fama & French, 1993; Chui & Wei, 1998; Griffin & Lemmon, 2002; and Vassalou & Xing, 2004). However, recent studies have examined the dynamics of NBE firms in relation to stock returns (Brown, et al, 2008; Jan & Ou, 2012; Ang, 2015).

Prior to 1980, the incidence of NBE was rare among US firms. However, the phenomenon has increased in recent years following more cases of net losses recorded by firms in the post-1980 era (Brown et al, 2008). The frequency of NBE firms and their persistence over time, make these phenomena important subject for research. Studies such as those of Brown, et al (2008), Jan and Ou (2012), and Ang (2015) report that most NBE firms remain in operations, and continue to trade in the stock market over several years. Indeed, Jan and Ou show that on a per-dollar of assets basis, the market prices NBE firms higher than their positive book equity (PBE) counterparts.

Although this seems counterintuitive, it may be because investors see beyond the firm's NBE in the current year, and expect the firm to record positive earnings and move back to PBE status in future years. When earnings are very low or negative in a given year, investors believe that the firm's current net income position does not necessarily indicate the direction of future performance. However, the situation gets more complicated when the firm's book equity also becomes negative perhaps after persistent losses. If investors are motivated by the expectation of future earnings and potential capital gains, what are the motivations for creditors who are usually more interested in the ability of the borrower to meet debt service obligations, and less by the potentials of future profit?

This study contributes to the literature by examining creditors' motivation for extending credit to firms with negative book equity. If NBE implies that a firm is either distressed or close to failure (Dichev, 1998), one would expect that such a firm should be unable to access the credit market because the firm's liabilities are more than its assets, and creditors may be concerned about the ability of the firm to meets its debt service obligations, as well as the repayment of principal on maturity. In general, research on creditor behavior is sparse compared to those on the behavior of investors (Billings & Morton, 2002).

But investors and creditors are motivated by different factors given their different rewards. As owners of the firm, investors receive a share of the firm's net income. On the other hand, creditors receive fixed interest payments depending on the terms of the debt contract. Creditors also expect a return of interest and principal amount at maturity. Consequently, sales revenue and operating cash flow can be more important to the creditor (Allen & Cote, 2005; Billings & Morton, 2002), while net operating income and capital gains would be the major consideration to the investor/owner of the business.

Given these differences, it is necessary to examine creditors' motivation in extending credit to NBE firms. If investors look up to a firm's Research & Development activities as indication of future profitability and returns (Jan & Ou, 2012), creditors are expectedly concerned about the ability of the firm to meet its maturing debt obligations.

The results show that NBE firms continue to issue new debt, with 72% of such firms issuing new long-term debt during the period in which the firms reported negative book equity, compared to 57% for firms with PBE. Our regression analyses show that the presence of positive sales revenue, rather than the firm's involvement in research and development activities, affect the ability of NBE firms to access the credit market all things being equal. This result may be because lenders see positive sales revenue as indication of the firm's ability to meet its debt service obligations despite having a negative book value. Interestingly, for the PBE firms, operating income, sales revenue and research and development activities are all significant variables affecting the firm's ability to issue new debt. However, for firms with NBE, only sales revenue is statistically significant. The rest of this paper proceeds as follows: section 2 reviews related literature. In section 3 we present the data and methodology for the study. Results are presented in section 4, and section 5 concludes the paper.

LITERATURE REVIEW

The book equity of a firm represents the value of the firm to its owners. It is simply the difference between the firm's total assets and its total liabilities. Traditionally, one would expect that a firm that satisfies the going concern principle should have a positive value of equity. This is because the limited liability rule does not mandate a firm's shareholders to make additional contributions to the firm beyond the shareholders' equity contribution. Given this reality, some argue that NBE firms should be considered technically distressed (Dichev, 1998). However, recent trends in the growing number of NBE firms, and the continued operations of such firms for many years call for alternative interpretations on the true nature of negative book equity.

Luo, Liu, and Tripathy (2019) found that NBE firms exhibit different characteristics, with many of these firms remaining operationally and financially stable despite reporting negative value of equity. The phenomenon of negative equity may well be largely a fallout of increasing accounting conservatism (Roychowdhury & Watts, 2007; Beaver & Ryan, 2005). The phenomenon may also be related to the business environment of the post-1980 period, including the rise of technology firms and associated increase in research and development activities, patents, and other forms of intellectual capital whose values are sometimes more complicated to determine, and which are sometimes not represented on the asset side of the balance sheet. Such activities as research and development spending increase the expense side of the income statement, and thus, reduce the profit of the firm, but is not reported as assets. Luo, Liu , and Tripathy (2019) observe that the quality of off-balance sheet and intangible assets of the NBE firm plays a factor in the firm's debt capacity.

In reference to the unique nature of high-tech firms, Francis and Schipper (1999) observe that intangibles such as research and development, patents, and technical skills or intellectual capital are becoming increasingly relevant in evaluating high-tech firms. On the other hand, they suggest that traditional measures of firms' performance usually contained in accounting information are decreasing in relevance. This phenomenon was pervasive during the boom in technology and internet businesses (dot.com era), where investors were willing to invest in firms with no cash flow or revenue of any sort, but with some high-sounding project ideas, and perhaps a few patents. In their study, Billings and Merton (2002) confirm that cash flow was of little or no relevance in determining the credit risk of high-tech firms, such as firms in the computer, telecommunication, and pharmaceutical industries, among others.

What these entails is that investors and lenders developed other means of assessing the credibility and creditworthiness of these firms, while placing little value in the traditional accounting information. In effect, even when the firms were making persistent losses, investors continued to inject more funds with the expectation that the intangibles in research and development and patents would translate to revenues in the future. However, while investors are owners of the firm who share in the residual profit or loss of the firm, lenders do not share in the profit of the business, but receive fixed payment of interest. These differences in rewards and motivations between equity holders and creditors means that each group must have different motivations.

A number of factors can lead a firm to the NBE territory. For example, a firm's book equity can become negative if the firm makes losses over a long period of time, such that these losses deplete owners' equity (Fama & French, 1992). In addition, significant bad debt provision, debt write-offs or other significant non-recurring charges can impact a firm's income negatively and lead to NBE (Burgstahler & Dichev, 1997; Kirschenheiler & Melumad, 2002). High or consistent negative retained...