Question

In its 1990 discussion memorandum on distinguishing between liabilities and equity, the FASB posed the question, "Should the sharp distinction between liabilities and equity be effectively eliminated?" To do so would be consistent with the equity theory of equity and with the notion that the capital structure (debt versus equity) of a firm is irrelevant to users of financial statements.

Side 1: Argue for elimination of the distinction between debt and equity. Support your argument by citing the entity theory of equity as well as the finance theory asserting that capital structure is irrelevant.

Side 2: Argue against the elimination of the distinction between debt and equity. Support your argument by citing the propriety theory of equity as well as the finance theory asserting that capital structure is relevant.

Choose one side and present your argument

Answer 1

Proprietary theory assumes that both the investor and the firm are one and equal. There is no distinction between the two. There is no seperate entity and corporate veil concept. All the assets and liabilities of the firm belongs to investor. Emphasis is placed on profits of the firm, which belong solely to the owner and not to any other member of the entity. This theory best applies to single proprietorship entities or firms because invairably owner and management is one and same.

Finance theory teaches that the value of an equity share is determined by its fundamental value i.e. expected discounted value of its future yield or dividends. This theory focuses on the dividend and earnings per share growth leading to increase in the equity,

THese theory suggest that the net assets and its growth relates to the owner i.e. equity shares holder because they take the risk of losses and receiving last payment. Further, financers does not take any risk and takes home fixed return on their loan. Financer does not enjoy rights over the assets of the firm provided they receive their payment on time. Hence, equity and liability are not same but two different concepts based on risk & return profile.