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. THANK YOU! • ANY QUESTIONS?