Top 5 Theories of Equity

The following points highlight the top five theories of equity. The theories are: 1. Proprietary Theory 2. Entity Theory 3. Fund Theory 4. Residual Equity Theory 5. Enterprise Theory.

1. Proprietary Theory:

Under the proprietary theory, the entity is the agent, representative, or arrangement through which the individual entrepreneurs or shareholders operate.

In this theory, the viewpoint of the owners group is the center of interest and it is reflected in the way that accounting records are kept and the financial statements are prepared. The primary objective of the proprietary theory is the determination and analysis of the proprietor’s net worth.

Accordingly, the accounting equation is viewed as:

Assets – Liabilities = Proprietor’s Equity

In other words, the proprietor owns the assets and liabilities. If the liabilities may be considered negative assets, the proprietary theory may be said to be asset centered and, consequently, balance-sheet oriented.

Assets are valued and balance sheets are prepared in order to measure the changes in the proprietary interest or wealth Revenues and expenses are as increases or decreases, respectively, in proprietorship not resulting from proprietary investments or capital withdrawals by the proprietor.

Thus, net income is an increase in the proprietor’s wealth to be added to capital. Losses, interest on debt, and corporate income taxes are expenses, while dividends are withdrawals of capital.

The proprietary theory has some influence of financial accounting techniques and accounting treatment of items. For example, ‘net income’ of a company, which is arrived at after treating interest and income taxes as expense, represents “net income to equity share holders” rather than to all providers of capital. Similarly, terms such as “earnings per share”, “Book value per share,” and “dividend per share” indicate a proprietary emphasis.

The proprietary theory has two classifications depending upon who is considered to be included in the proprietary group. In the first type, only the common shareholders are part of the proprietor group, and preferred shareholders are excluded. Thus, preferred dividends are deducted when calculating the earnings of the proprietor (equity shareholders).

This narrow form of the proprietary theory is identical to the “residual equity” concept in which the net income is extended to deduct preferred dividends and arrive at net income to the residual equity on which will be based the computation of earnings per share.

In the second form of the proprietary theory, both the common capital and preferred capital are included in the proprietor’s equity. Under this wider view, the focus of attention becomes the shareholders’ equity section in the balance sheet and the amount to be credited to all shareholders in the income statement.

2. Entity Theory:

In entity theory, the entity (business enterprises) is viewed as having separate and distinct existence from those who provided capital to it. Simply stated, the business unit rather than the proprietor is the center of accounting interest. It owns the resources of the enterprises and is liable to both, the claims of the owners and the claims of the creditors.

Accordingly, the accounting equation is:

Asset = Equities or

Assets = Liabilities + Shareholders’ Equity

Assets are rights accruing to the entity, while equities represent sources of the assets, consisting of liabilities and the shareholders’ equity. Both the creditors and the shareholders are equity holders, although they have different rights with respect to income, risk, control and liquidation.

Thus, income earned is the property of the entity until distributed as dividends to the shareholders. Because the business unit is held responsible for meeting the claims of the equity holders, the entity theory is said to be income centered and consequently, income statement oriented.

Accountability to the equity holders is accomplished by measuring the operating and financial performance of the firm. Accordingly, income is an increase in the shareholders’ equity after the claims of other equity holders are met—for example, interest on long-term debt and income taxes.

The increase in shareholder’s equity is considered income to the shareholders only if a dividend is declared. Similarly, undistributed profits remain the property of the entity because they represent the “company’s proprietary equity in itself.”

It should be noted that strict adherence to the entity theory would dictate that interest on debt and income taxes be considered distributions of income rather than expenses. The general belief and interpretation of the entity theory, however, is that interest and income taxes are expenses.

The entity theory is most applicable to the corporate form of business enterprise, which is separate and distinct from its owners. The impact of the entity theory may be found in some of the accounting techniques and terminology used in practice.

First, the entity theory favours the adoption of LIFO inventory valuation rather than FIFO because LIFO achieves a better income determination. Because of its better inventory valuation on the balance sheet, FIFO may be considered a better technique under the proprietary theory.

Second, the common definition of revenue as product of an enterprise and expenses as goods and services consumed to obtain this revenue is consistent with the entity theory’s preoccupation with an index of performance and accountability to equity holders.

Third, the preparation of consolidated statements and the recognition of a class of minority interest as additional equity holders is also consistent with the entity theory.

Finally, both the entity theory, with its emphasis on proper determination of income to equity holders, and the proprietary theory, with its emphasis on proper asset valuation, may be perceived to favour the adoption of current values or valuation bases other than historical costs.

3. Fund Theory:

The fund theory emphasizes neither the proprietor nor the entity but a group of assets and related obligations and restrictions governing the use of the assets called a “fund.” Thus, the fund theory views the business unit as consisting of economic resources (funds) and related obligations and restrictions in the use of these resources.

The accounting equation is viewed as:

Assets = Restriction of Assets

The accounting unit is defined in terms of assets and the uses to which these assets are committed. Liabilities represent a series of legal and economic restrictions on the use of the assets. The fund theory is therefore asset centered in the sense that it places primary focus on the administration and appropriate use of asset.

Neither the balance sheet nor the financial statement is the primary objective of financial reporting hut the statement of sources and uses of funds is most important. This statement measures the operations of the firm in terms of sources and dispositions of funds.

The fund theory is useful primarily to government and non-profit organizations. Hospitals, universities, cities and governmental units, for example, are engaged in multifaceted operations that use separate several funds. For such organisations, the information about sources and uses of funds is very useful as compared to financial statement information.

4. Residual Equity Theory:

The residual equity theory is a concept somewhere between the proprietary theory and the entity theory. In this view, the equation becomes Assets – Specific equities = Residual equity. The specific equities include the claims of creditors and the equities of preferred shareholders.

However, in certain cases where losses have been large or in bankruptcy proceedings, the equity of the common shareholders may disappear and the preferred shareholders or the bondholders may become the residual equity holders.

The objectives of the residual equity approach is to provide better information to equity shareholders for making investment decision. In a company with indefinite continuity, the current value of equity share is dependent primarily upon the expectations of future dividends.

Future dividends, in turn, are dependent upon the expectations of total receipts less specific contractual obligations, payments to specific equity holders, and requirements for reinvestments.

Trends in investment values can also be measured, in part, by looking at trends in the value of the residual equity measured on the basis of current values. The income statement and statement of retained earnings should show the income available to the residual equity holders after all prior claims are met, including the dividends to preferred shareholders.

The equity of the common shareholders in the balance sheet should be presented separately from the equities of preferred shareholders and other specific equity holders. The funds statement should also show the funds available to the firm for the payment of common dividends and other purposes.

5. Enterprise Theory:

The enterprise theory of the firm is a broader concept than the equity theory, but less well defined in its scope and application. In the entity theory, the firm is considered to be a separate economic unit operated primarily for the benefit of the equity holders, whereas in the enterprise theory the company is a social institution operated for the benefit of many interested groups.

In the broadest form these groups include, in addition to the shareholders and creditors, the employees, customers, the government as a taxing authority and as a regulatory agency, and the general public. Thus the broad form of the enterprise theory may be thought of as a social theory of accounting.

The enterprise theory concept is largely applicable to large companies which should consider the effect of its actions on various groups and on society as a whole. From an accounting point of view, this means that the responsibility of proper reporting extends not only to shareholders and creditors, but also to many other groups and to the general public.

The most relevant concept of income in this broad social responsibility concept of the enterprise is the value-added concept. The total value added by the enterprise is the market value of the goods and services produced by the firm less the value of the goods and services acquired by transfer from other firms.

Thus, value-added income includes all payments to shareholders in the form of dividends, interest to creditors, wages and salaries to employees, taxes to governmental units, and earnings retained in the business. The total value-added concept also includes depreciation, but this is a gross product concept rather than a net income concept.

The position of retained earnings in the enterprise theory is similar to its position in the entity concept. It either represents part of the equity of the residual equity holders or it represents undistributed equity—the equity of the company in itself.

In entity theory there is considerable merit in the former position; but in the enterprise theory the earnings reinvested do not necessarily benefit only the residual equity holders.

Capital employed to maintain market position, to improve productivity, or to promote general expansion may not necessarily benefit only the shareholders. In fact, it is possible that the shareholders may not be benefited at all if future dividends are not increased.

In conclusion, it can be said that the different equity theories (approaches) are found to be relevant under different circumstances of organization, economic relationships, and accounting objectives. Therefore, accounting theory and practice should take an eclectic approach to these theories. All help to explain and understand accounting theory and to develop logical patterns for the extension of theory.

However, care must be taken to apply the most logical equity theory in each case and to use a single theory consistently in the similar situations. It is not inconsistent to apply the proprietary concept to a small single proprietorship, the entity concept to a medium size concern and the enterprise theory to a very large company.

Hendriksen observes:

Each of the several equity theories interprets the economic position of the enterprise in a different way and thus presents a different emphasis on the method of disclosure of the interest of the several equity holders or interested groups. They also lead to different concepts of income or different methods of disclosing the equity interests in the income of the enterprise.

There is also some evidence that the proprietary concept requires an emphasis on current valuations of assets, the entity and funds theories are neutral with respect to asset valuation, and the enterprise theory emphasizes the need for a market output valuation concept.

However, the associated valuation method and the associated concept of income are primarily the result of the way several concepts have been developed. The problem of valuation and the most relevant concept of income are basically independent of equity theory selected. The main questions raised by the several equity concepts are related to these questions.

(1) Who are the beneficiaries of net income?

(2) How should the equity relationships be shown in the financial statements?

These questions are closely related to the objectives of accounting.