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The Equity Theories and

Financial Reporting: An
Analysis
by :
Wiji Astuti 7101415195
Okta Kissita F.P 7101415084

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TOPICS
1.Introduction
2.Equity Theories: A Literature Review
3.Equity Theories: Implications for Financial
Reporting
4.The Conceptual Framework and Equity
Theories
5.Conclusions
Introduction
In revising and converging their conceptual frameworks the IASB and the FASB
initially made reference to entity theory and the contrasting proprietary theory.
The literature indicates that proprietary views of the company see the purpose of
income determination as measuring the increase in wealth of the owners using the
asset–liability approach leading to net income to common shareholders as the
bottom line.
This paper contributes to a clearer definition and understanding of entity and
proprietary views of companies. It shows that the entity view of the firm is
inconsistent with the asset–liability approach to income determination.

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Equity Theories: A Literature
Review
 Equity theories were a popular topic of journal articles from the 1930s to the 1960s.
According to Mattessisch (2008, pp. 29–30), entity theory only fully replaced
proprietary theory in the second half of the 20th century.
 Functions of Equity Theories :
1. According to Hendriksen and Van Breda (1992, p. 766) equity theories interpret the
economic position of the enterprise in a different way leading to a different
emphasis in disclosing the interests of stakeholders as well as different concepts of
income.
2. More specifically, chroeder et al. (2001, p. 305) claim that ‘Theories of equity
postulate how the balance sheet elements are related and have implications for
the definitions of both liabilities and equity.’ Zeff (1978, p. 1) uses the term
‘orientation postulate’ with regard to the point of view taken in the accounting
process because whether explicit or implicit, ‘a perspective must find expression
somewhere in the theoretical construct’.
3. Lorig (1964) believed that the direct impact of equity theories is limited to items
which appear on the credit side of the balance sheet, including debt capital, equity
capital and possibly ‘the equity of the accounting entity in itself’ (p. 564).
Proprietary theory view

1. Proprietary theory is an agency concept. In a traditional agency


setting financial reports are prepared by the managers for the
purpose of providing information to the proprietors on the basis
of which, the managers were held accountable for their
stewardship.
2. the accounting equation: assets −liabilities =proprietorship or
net worth
3. Under traditional proprietary theory the distinction between
debt and equity is absolute. This relates to the fact that
proprietorship is determined as net assets. Equity is not
considered a liability of the entity to the proprietor except for
bookkeeping purposes.
The residual equity view

1. Residual equity theory is a variation of proprietary theory which


explicitly takes into account the change in the nature of the
business entity from a legal view when a business becomes
insolvent.
2. Accounting and financial reporting should take the point of view
of investors because the function of financial reporting is to
provide information to suppliers of capital.
3. The accounting equation according to the residual equity theory
is (Staubus, 1959, p. 13): Assets − Specific Equities (= Liabilities +
Preferred Stock) = Residual Equity.
4. In normal business situations specific equities include the claims
of creditors, long-term lenders and preferred shareholders.
However, in abnormal business circumstances ‘the equity of
common stockholders may disappear and the preferred
stockholders or bond holders may become the residual equity
holders’ (Hendriksen and Van Breda, 1992, p. 773).
The equity view (in between proprietary and entity)

1. The equity view corresponds largely to Paton and Littleton’s


application of the entity theory (1940).
2. In this view financial accounting and reporting serve the purpose
of accountability to the suppliers of both debt and equity capital,
and must report information that is useful for their investment
and resource allocation decisions.
3. The balance sheet equation under this view as found in
Hendriksen and Van Breda (1992, p. 771) describing the entity
view is as follows: assets =debt capital +stockholders′ equity
capital.
4. To the extent that there is a sharp distinction between debt and
equity in the accounting for transactions with shareholders, the
equity view becomes a proprietary view instead of an entity
view.
 Entity theory

1. Entity theory developed out of the concept of limited liability of


a company’s shareholders. ‘Littleton considers medieval agency
accounting a forerunner of the entity theory, which in this sense
predated the corporation itself’ (Chatfield, 1977, p. 224).
2. Entity theory views the entity as ‘having a separate existence –
an arms length relationship with its owners. The relation to the
owners is regarded as not particularly different from that to the
long-term creditors’ (Lorig, 1964, p. 566).
3. In other words, the company’s assets belong to the entity
instead of to the shareholders.
The self-equity view

1. The second and newer interpretation of the entity theory


regards ‘the entity as in business for itself and is interested in its
own survival’ (Kam, 1990, p. 306).
2. The purpose of financial accounting in this case is to meet legal
requirements and to maintain good relationships with suppliers
of debt and equity capital as a means to ensure its survival and
enable the business entity to raise additional capital if necessary
(Kam, 1990, p. 306).
3. The accounting equation according to the entity theory
following Paton (1922) is
assets =liabilities OR assets =equities.
The self-equity view is a pure form of the entity theory because
it sees debt and equity as liabilities of the business entity. The
contractual obligations are different in nature, but for a going
concern in the self-equity view these differences only matter in
terms of finding the optimal mix of sources of funding to suit its
strategic, operational and financing objectives.
The social view/enterprise theory

1. The enterprise theory sees the large listed corporation as an


institution with social responsibilities. It is therefore a broader
concept than the self-equity form of entity theory.
2. Companies’ actions affect many different stakeholders such as
stockholders, creditors, customers, employees, the government
as a taxing and regulatory authority and the public at large
(Suojanen, 1954; Kam, 1990; Hendriksen and Van Breda, 1992).
3. The enterprise theory considers that output is the relevant
measure of income in the value added statement; profitability or
net income, is measured in the income statement. It follows that
the amount appearing in the retained earnings account is
imputed to the enterprise. (Suojanen, 1954, p. 396)
The boundaries of the accounting entity under the entity views

1. Lorig was of the opinion that according to the entity theory


consolidated financial statements present an inappropriate view
because the relation between a parent and a subsidiary
company is of a debtor–creditor rather than ownership nature
(1964, pp. 570–571).
2. Majority shareholders, current and prospective investors and
long-term creditors require information about the activities and
resources of the overall economic entity. In addition, top
management is generally evaluated on the basis of the overall
performance reflected in the consolidated financial statements
(Baker et al., 2005, p. 98–99)
3. Therefore, under the entity approach the emphasis is on the
consolidated economic entity itself. Controlling and non-
controlling shareholders are viewed as two separate groups with
an equity stake in the consolidated entity neither of which is
emphasised over the other.
Equity Theories: Implications for
Financial Reporting

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The Conceptual Framework
and Equity Theories
Following the comments on the Exposure Draft, the IASB and
FASB are likely to abandon any reference to entity and
proprietary theories in the objectives of financial reporting.
The conceptual framework project has fully embraced a
decision-usefulness perspective where income as determined by
the asset–liability approach is meant to help estimate the
timing, risk and amount of cash flows to investors.
The real evidence will be in the accounting standards that follow
from the Conceptual Framework.
Conclusions
This literature review shows that the proprietary and entity theories
originated at different times in history and have not been developed
continuously since. The equity theory literature is notably undeveloped
with respect to the determination of the boundaries of the reporting
entity.
For accounting standard setters, be they private or public, the choice for
a view of the company must be guided by the objective of accounting
regulation with regard to social objectives and the political influence of
different constituencies.
Fair value accounting for financial instruments without giving recognition
to the role of financial accounting and reporting in the incentives for
management to abuse off-balance sheet entities, recognise, derecognise
and leverage financial assets may have contributed to irresponsible risk
taking and a strong orientation towards short-term performance
indicators.
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