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Theories of Equity

The document discusses two theories of equity: the proprietary theory and the entity theory. The proprietary theory views the firm as being owned by individuals or groups, with assets belonging to owners and liabilities also belonging to owners. Revenues and expenses directly impact the owners' net interest. This theory was prominent when owners' interests guided financial reporting but became less relevant as other users' interests grew in importance. The proprietary theory sees financial reporting as focusing on the owner and is best suited to sole proprietorships, becoming less applicable as ownership and management separate in more complex organizations.

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1K views1 page

Theories of Equity

The document discusses two theories of equity: the proprietary theory and the entity theory. The proprietary theory views the firm as being owned by individuals or groups, with assets belonging to owners and liabilities also belonging to owners. Revenues and expenses directly impact the owners' net interest. This theory was prominent when owners' interests guided financial reporting but became less relevant as other users' interests grew in importance. The proprietary theory sees financial reporting as focusing on the owner and is best suited to sole proprietorships, becoming less applicable as ownership and management separate in more complex organizations.

Uploaded by

Javian Negrón
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© © All Rights Reserved
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Reporting Equity 1

theories of Equity
ChSptSI 11 introduced two theories of equity: the proprietary theory and the entity theory. These and several other theories may provide a frame of reference for the presentation and measurement of information reported in ii nor tool statements. When viewing the applicability of the various theories of equitv, it. is important to remember that the purpose of a theory is to provide a rationale or explanation for some action. The proprietary theory gained prominence because the interests of owners were seen as the guiding force in the preparation of fiiian- eial statements. However, as the interests of other users became more significant, accountants made changes in financial reporting formats without adopting a particular equity theory, In the following discussion, the student should keep in mind that the adoption of a particular theory could influence a number of accounting and reporting procedures. The student should also note that the theories represent a point of view toward the firm for accounting purposes that is not necessarily the same as the legal view of the firm.

Proprietary Theory
According to the proprietary' theory, the firm is owned by some specified person or group. The ownership interest may be represented by a sole proprietor, a partnership, or a number of stockholders. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners' liabilities. Revenues received by the firm immediately increase the owner's net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. This theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they arc distributed. Therefore the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as assets liabilities = proprietorship Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company's financial statements. The proprietary theory is particularly applicable to sole proprietorships where the ownei is the decision maker. When the form of the enterprise grows more complex and the ownership and management separate, this theory becomes less acceptable An attempt has been made to retain the concepts of the proprietary theory in the corporate situation; however, many accountants have asset ted that it cannot meet the requirements of the corporate form of organization.~ Nevertheless, we still find significant accounting policies that can be justified only through acceptance of the proprietary theory. For example, the calculation and presentation of earnings per share figures are relevant only it we assume that those earnings belong to lfie shareholders before the declaration of dividends.

Ibid.

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