Question

Several theories try to explain and defined equities but lead to different application in accounting, explain these theories and some applications in accounting? Use equity components in your explanation to define equity and its main characteristics?

Answer 1

Equity in a business enterprise stems from ownership rights. It involves a relation between an enterprise and its owners as owners rather than as employees, suppliers, customers, lenders or in some other non-owner role

(a) Equity is the same as net assets, the difference between the enterprise’s assets and its liabilities and

(b) Equity is enhanced or burdened by increases and decreases in net assets from sources other than investments by owners and distributions to owners. Owners’ equity is the interest that, perhaps in varying degrees, bears the ultimate risk of enterprise failure and reaps the ultimate rewards of enterprise success.

2. Equity represents the source of distributions by an enterprise to its owners, whether in the form of cash dividends or other distributions of assets. Owners’ and others’ expectations about distributions to owners may affect the market prices of an enterprise’s equity securities, thereby indirectly affecting owner’ compensation for providing equity or risk capital to the enterprise. Thus, the essential characteristics of equity centre on the conditions for transferring enterprise assets to owners.

Equity—an excess of assets over liabilities—is a necessary but not sufficient condition. Generally, an enterprise is not obligated to transfer assets to owners except in the event of the enterprise’s liquidation unless the enterprise formally acts to distribute assets to owners, for example, by declaring a dividend. In this way, owners’ equity has no maturity date.

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Owners may sell their interest in an enterprise to others and thus may be able to obtain a return of part or all their investments and perhaps a return on investments through a securities market, but those transactions do not normally affect the equity of an enterprise or its assets or liabilities.

3. An enterprise may have several types of equity (e.g., equity shares, preference share) with different degrees of risk stemming from different rights to participate in distributions of enterprise assets or different priorities of claims on enterprise assets in the event of liquidation. That is, some classes of owners may bear relatively more of the risks of an enterprise’s unprofitability or may benefit relatively more from its profitability (or both) than other classes of owners.

4. Owners equity is originally created by owners’ investments in an enterprise and may from time to time be augmented by additional investments by owners. Equity is reduced by distributions by the enterprise to owners.

However the distinguishing characteristics of owners’ equity is that it inevitably decreases if the enterprise is unprofitable and inevitably increases if the enterprise is profitable, reflecting the fact that owners bear the ultimate risks of and reap the ultimate rewards from the enterprise’s operations and the effects of other events and circumstances that affect it. Ultimately, owners’ equity is the interest in enterprise assets that remain after liabilities are satisfied, and in that sense it is a residual.