Residual Equity Theory

DEFINITION of Residual Equity Theory

Residual equity theory assumes common shareholders to be the real owners of a
business. Their residual equity, or net income, is calculated by subtracting the
claims of bondholders and preferred shareholders from a company's assets.

Common stock = Assets - Liabilities - Preferred Stock

BREAKING DOWN Residual Equity Theory

Residual equity theory was developed by Professor George Staubus at the
University of California, Berkeley's Haas School of Business. An advocate for the
continued improvement of the standards and practices of financial reporting, he
argued its primary objective should be to provide information that is useful in
making investment decisions.

Staubus' decision-usefulness theory was the first to link cash flows to the
measurement of assets and liabilities, and their importance in investment
decisions. It would eventually become the basis for generally accepted
accounting principles and the Financial Accounting Standards Board's
conceptual framework.

Because common shareholders are the last in line to be repaid if the company
goes bust, he argued they should be given sufficient information about corporate
finances and performance to make sound investment decisions. This led to
the earnings per share calculation that applies only to common stockholders.

Residual Equity Theory vs. Proprietary Theory

Residual equity theory is an alternative to the proprietary theory of accounting,
which calculates the owner's net worth as assets minus liabilities. Proprietary
theory, which treats the owner of an enterprise as an extension of the firm itself,
is most applicable to partnerships and sole proprietorships.

Other equity theories include the entity theory, in which a firm is treated as a
separate entity from owners and creditors, and its income is its property until
distributed to shareholders. Enterprise theory goes further and considers the
interests of stakeholders such as employees, customers, government agencies
and society.
 The realization principle
The realization principle is the concept that revenue can only be recognized once the underlying
goods or services associated with the revenue have been delivered or rendered, respectively.
Thus, revenue can only be recognized after it has been earned. The best way to understand the
realization principle is through the following examples:

 Advance payment for goods. A customer pays $1,000 in advance for a custom-designed product.
The seller does not realize the $1,000 of revenue until its work on the product is complete.
Consequently, the $1,000 is initially recorded as a liability (in the unearned revenue account),
which is then shifted to revenue only after the product has shipped.

 Advance payment for services. A customer pays $6,000 in advance for a full year of software
support. The software provider does not realize the $6,000 of revenue until it has performed
work on the product. This can be defined as the passage of time, so the software provider could
initially record the entire $6,000 as a liability (in the unearned revenue account) and then shift
$500 of it per month to revenue.

 Delayed payments. A seller ships goods to a customer on credit, and bills the customer $2,000
for the goods. The seller has realized the entire $2,000 as soon as the shipment has been
completed, since there are no additional earning activities to complete. The delayed payment is
a financing issue that is unrelated to the realization of revenues.

 Multiple deliveries. A seller enters into a sale contract under which it sells an airplane to an
airline, plus one year of engine maintenance and initial pilot training, for $25 million. In this
case, the seller must allocate the price among the three components of the sale, and realizes
revenue as each one is completed. Thus, it probably realizes all of the revenue associated with
the airplane upon delivery, while realization of the training and maintenance components will
be delayed until earned.

The realization principle is most often violated when a company wants to accelerate the
recognition of revenue, and so books revenues in advance of all related earning activities being
completed.

Auditors pay close attention to this principle when deciding whether the revenues booked by a
client are valid.
Realization concept in accounting, also known as revenue recognition
principle, refers to the application of accruals concept towards the recognition
of revenue (income). Under this principle, revenue is recognized by the seller
when it is earned irrespective of whether cash from the transaction has been
received or not.

Explanation

In case of sale of goods, revenue must be recognized when the seller

transfers the risks and rewards associated with the ownership of the goods to
the buyer. This is generally deemed to occur when the goods are actually
transferred to the buyer. Where goods are sold on credit terms, revenue is
recognized along with a corresponding receivable which is subsequently
settled upon the receipt of the due amount from the customer.

In case of the rendering of services, revenue is recognized on the basis of

stage of completion of the services specified in the contract. Any receipts from
the customer in excess or short of the revenue recognized in accordance with
the stage of completion are accounted for as prepaid income or accrued
income as appropriate.

Importance

Application of the realization principle ensures that the reported performance

of an entity, as evidenced from the income statement, reflects the true extent
of revenue earned during a period rather than the cash inflows generated
during a period which can otherwise be gauged from the cash flow statement.
Recognition of revenue on cash basis may not present a consistent basis for
evaluating the performance of a company over several accounting periods
due to the potential volatility in cash flows.