Question

when and how was entity theory and proprietorship theory introduced?

Answer 1

History

The entity theory is often developed in accounting literature by referring to the time of the Roman Empire where there were slaves acting in business ventures for their masters. A master would give his slave a certain amount of money or goods which the slave was to invest wisely. When profits were made, the gains were turned over to the master. The slave was owned by the master and all that the slave possessed belonged to the master but the slave carried on the business of the enterprise as a separate party. Such an example can illustrate the entity or proprietary theory depending on how it is used. If the slave is considered as a person independent of his master*s actions, the entity theory of enterprise results. By definition, however, a slave has no right to own property in his own name, and hence, the illustration is more suitable to the proprietary theory because the property ownership was in the hands of the slave owner, with the slave being merely an appendage of the owner.

Proprietary Theory:

Under this theory entity is the agent , representative, or arrangement through which the individual entrepreneurs or shareholders operate.

In this theory, the viewpoint of the owners group is the center of interest and it is reflected in the way that accounting records are kept and the financial statements are prepared. The primary objective of the proprietary theory is the determination and analysis of the proprietor’s net worth.

The proprietary theorists claim there is a double tax on corporate and stockholders’ income because both stockholders and corporations are taxed on the same income.

The proprietary theory is a stockholders’ approach and the formula                 Assets - Liabilities = Capital is appropriate because it demonstrates the stockholders as the residual claimants.

The proprietary theory has some influence of financial accounting techniques and accounting treatment of items. For example, ‘net income’ of a company, which is arrived at after treating interest and income taxes as expense, represents “net income to equity share holders” rather than to all providers of capital. Similarly, terms such as “earnings per share”, “Book value per share,” and “dividend per share” indicate a proprietary emphasis.

2.Entity Theory

In entity theory, the entity (business enterprises) is viewed as having separate and distinct existence from those who provided capital to it. Simply stated, the business unit rather than the proprietor is the center of accounting interest. It owns the resources of the enterprises and is liable to both, the claims of the owners and the claims of the creditors.

Accordingly, the accounting equation is:

Asset = Equities or

Assets = Liabilities + Shareholders’ Equity

Assets are rights accruing to the entity, while equities represent sources of the assets, consisting of liabilities and the shareholders’ equity. Both the creditors and the shareholders are equity holders, although they have different rights with respect to income, risk, control and liquidation.

According to entity theory, owners of a company cannot be held personally liable for its debts and liabilities. Hence, creditors cannot acquire the personal assets or property of the owner for recovering the remaining debt amounts.

As per the entity theory, liabilities refer to equities that have distinct legal rights in the organization. Considering the accounting perspective, the entity theory considers company’s monetary aspects such as liabilities, assets, incomes, revenues, etc. distinct from the owner’s personal expenses and money-related operations. Hence, this leads to the separation of identity for owners and managers, and the company itself.

Entity approach, there is no double taxation situation, because the tax is levied on a separate and distinct entity which can be so identified. The law permits deductions which are necessary to produce income or which cause losses. Dividends are not considered deductible but interest on borrowed capital is a deductible expense.