Theories of Equity Chapter 11 introduced two theories of equity: the proprietary theory and the entity theory. These and several other theories can provide a frame of reference for the presentation and measurement of information reported in financial statements. When viewing the applicability of the various theories of equity, 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 financial 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, two or more partners, members of a limited liability company, or a number of stockholders. Proprietary theorists view the assets of the firm as belonging to these owners and any liabilities of the firm as obligations of the owners. Consequently, 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 are distributed to the owners. 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 owner is the decision maker. When the form of the enterprise grows more complex, and the ownership and management become separate, this theory becomes less acceptable. However, it can still be argued that the proprietors are residual owners who will receive what is left of the company's assets should the business be terminated and its obligations satisfied. Thus, the net assets (assets minus liabilities) can be viewed as belonging to the proprietors. However, given the typical accounting assumption of a going concern, this view in a corporate business structure managed by nonowners loses relevance. Thus, many accountants have asserted that it cannot meet the requirements of the corporate form of organization.
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