Question

CASE 15‐12 Debt versus Equity

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.

Required:

1. Discuss the entity theory rationale for making no distinction between debt and equity.
2. Is entity theory or proprietary theory consistent with modern theories of finance—that is, does the firm’s capital structure make a difference? Explain.

Answer 1

Ans 1. Preparation of accounting data of company from the view of Company's accounting, that;s what an Entity Theory say.There is no difference between debt and equity from the perspective of Entity's Theory. Further, there is no difference between liability and owner's equity. As per the Entity theory both require separate disclosure in the balance sheet and there is no sub total of liabilities and equity. Likewise debt equity ratio would not give desired or relevant information for investor decision making.

Ans 2. Yes, the firm's capital structure makes a difference as per the view of entity theory and proprietary theory. Entity theory believes from the perspective of entity only. The assets and liabilities belong to the firm as per entity's theory. Revenue receipts are the income of entity, likewise expenses incurred are expenses of entity.

Whereas, Proprietary theory believes that the entity belongs to the specified number of investors or a group of persons. All assets belongs to them and liabilities are on behalf of these group of persons only. Likewise, Revenue receipts results in increment of Owner;s interest in the entity as per Proprietary theory.

Hence, both Entity and Proprietary theory talks about different perspective, that's why firm's capital structure makes a difference.