Question

The entity theory of equity implies that there should be no need for financial statements to distinguish between debt and equity. Alternatively, proprietary theory implies that such a distinction is necessary and yields information vital to owners and potential stockholders. Discuss the entity theory rationale for making no distinction between debt and equity.

Answer 1

Solution:-

Discuss the entity theory rationale for making no distinction between debt and equity:-

Entity theorist believe that companies’ accounting should be prepared from the accounting entity’s view instead of in the interest of the shareholders. According to the entity theory, there is no fundamental difference between liabilities and owners equity. Both provide capital to the business entity and receive income in return in the form of interest and dividends (Schroeder, Clark, & Cathey, 2009, page 363). Under entity theory, liabilities and equity would require separate line disclosure in the balance sheet, but there would be no subtotals for total liabilities or total equity. Schroeder, Clark, & Cathey, 2009, page 363). Both are considered a source of capital, and the operations of the firm are not affected by the amount of the debt relative to equity (Schroeder, Clark, & Cathey, 2009, page 500). Under the entity theory, debt-to-equity ratios would not provide relevant information for investor decision making (Schroeder, Clark, & Cathey, 2009, page 500). Present accounting practice makes a sharp distinction between debt and equity (page 500). The recent exposure draft and SFAS No. 50 makes it evident that FASB favors the position that balance sheets should distinguish between debt and equity (page 500). The Is entity theory or proprietary theory consistent with modern theories of finance- that is, does the firm’s capital structure make a difference? Explain. There are two types of equity theories: entity theory and proprietorship (page 498). The purpose of a theory is to provide a rationale or explanation for some action (page 498) The proprietary theory views the net assets of the firm as belonging to the owners. (Schroeder, Clark, & Cathey, 2009, page 363).

Under this theory, equity is equal to the net worth of the owners (Schroeder, Clark, & Cathey, 2009, page 363). The proprietary theory relationship is articulated as assets-liabilities=equity (Schroeder, Clark, & Cathey, 2009, page 363). The entity theory and the proprietary theory is a point of view toward the firm and the people concerned ith its operation (Schroeder, Clark, & Cathey, 2009, page 499). The entity theory places the firm, and not the owners at the center of interest for accounting and financial reporting purposes (Schroeder, Clark, & Cathey, 2009, page 499).

The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups (Schroeder, Clark, & Cathey, 2009, page 499). The assets and liabilities belong to the firm, and not to its owners (Schroeder, Clark, & Cathey, 2009, page 499). As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity (Schroeder, Clark, & Cathey, 2009, page 499).

Profits belong to the firm also, and accrue to the stockholders when dividends are declared (Schroeder, Clark, & Cathey, 2009, page 499). Proprietary theory believers view net income as accruing to owners and entity theory view net income as accruing to the firm (page 500) The debt levels of a company can be measured by comparing its liabilities to its assets and to its liabilities, and according the debts-to-assets ratio and deb-to-eqity ratios are the metrics used in the analysis (page 507).

According to entity theory, the consolidated group ( parent compnay and subsidiaries), is an entity separate from its owners (page 543). Proprietary theory believes that the firm is owned by some specified person or group. (page 498) The assets belong to these owners, any liabilities of the firm are also the owners liabilities (page 498). Revenues received immediately increase the owners net interest in the firm (page 498).

All profit and losses immediately become the prperty of the owners, whether they are distributed or not (page 498) All expenses incurred immediately decrease the net prprietary interest in the firm (page 498). Proprietary equals Assets – liabilities = proprietorship (page 498) Proprietary theory financial reporting is based n the owner being the main focus (page 498) It is applicable to sole proprietorships where the owner is the decision maker (age 498) It does not meet the requirements to work for corporate form of organization (page 498).