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Accounting in Europe
Vol. 7, No. 2, 191 – 211, December 2010

The Equity Theories and Financial

Reporting: An Analysis

CARIEN VAN MOURIK

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Open University Business School, Milton Keynes, UK

ABSTRACT This paper reviews accounting literature in the English language on proprietary
and entity theory in order to understand their implications for financial accounting and
reporting. Although there is a lack of agreement on the definition and accounting
implications of the various equity theories, the literature indicates clear differences
between pure proprietary and pure entity perspectives of the firm. These differences
particularly relate to the purpose of accounting and financial reporting, the distinction
between debt and equity and its accounting implications for the analysis and recording of
transactions and recordable events, and the definition, determination, disclosure and
distribution of income. The main contribution of this paper is twofold. First, it explains in
operational terms why an entity perspective of the company is theoretically irreconcilable
with the asset – liability approach to the determination of income. Second, it makes clear
that there is always an implicit perspective to financial reporting. Inconsistency in
accounting standards results if the implicit perspective is not the same as the perceived
focus of decision-usefulness.

1. Introduction

In revising and converging their conceptual frameworks the IASB and the FASB
initially made reference to entity theory and the contrasting proprietary theory.
The comment letters (IASB, 2008) in response to the Exposure Draft (IASB/
FASB, 2008a) showed that the once keen debates of 50 years ago and more on
competing equity theories have largely been forgotten. This paper reviews
accounting literature in the English language in order to illuminate the past
debate. It addresses three questions:

Correspondence Address: Carien van Mourik, Open University Business School, Walton Hall, Milton
Keynes MK7 6AA, UK. Email: C.M.VanMourik@open.ac.uk

1744-9480 Print/1744-9499 Online/10/020191– 21 # 2010 European Accounting Association

DOI: 10.1080/17449480.2010.511885
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.
 192 C. van Mourik

. How have researchers defined entity and proprietary theories in the past?
. How are accounting and reporting different under entity theory compared to
proprietary theory?
. How do these differences interact with the IASB/FASB Conceptual Frame-
work project?

The International Accounting Standards Board (IASB) and Financial Accounting

Standards Board’s (FASB) Conceptual Framework project aims to update and
converge the existing FASB and IASB conceptual frameworks. In their exposure
draft on the objectives of financial reporting the boards included the comment: ‘The
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boards decided that an entity’s financial reporting should be prepared from the
perspective of the entity (entity perspective) rather than the perspective of its owners
or a particular class of owners (proprietary perspective)’ (IASB/ FASB, 2008a, p. 5).
Comments from constituents suggested that the boards did not understand the
differences between these two approaches and in the final version the reference to
these theories is likely to be omitted. If even the standard setters had no clear grasp
of these theories, it seemed useful to prepare a detailed analysis that might help to
illuminate such debates.
The literature indicates that proprietary views of the company see the purpose
of income determination as measuring the increase in wealth of the owners
using the asset – liability approach leading to net income to common
shareholders as the bottom line. Retained earnings are typically perceived as
belonging to the share-holders. A proprietary notion of decision-usefulness gives
priority to the infor-mation needs of investors in stocks and shares and
nominally includes the needs of debt security holders.
There appear to be conflicting interpretations of entity theory leading to incon-
sistencies in accounting treatments advocated by various theorists. Pure entity views
of the firm however, regard the purpose of income determination as provid-ing a
measure of performance using the revenue – expense approach which enables the
company’s survival and the alignment of all its stakeholders’ inter-ests. The
liabilities side of the balance sheet does not distinguish debt from equity but shows
liabilities in order of decreasing seniority. The income state-ment shows
expenditures incurred to satisfy obligations to all stakeholders either as expenses in
the determination of enterprise income or as distributions of enterprise income.
Retained earnings are perceived as belonging to the company. A pure entity notion of
decision-usefulness gives priority to the infor-mation needs related to the entity’s
survival and the coordination of all the stake-holders’ interests, and ideally also to
contribution and accountability to society.
This paper contributes to a clearer definition and understanding of entity and
proprietary views of companies. It shows that the entity view of the firm is
incon-sistent with the asset – liability approach to income determination. This
may be of importance to the IASB/FASB Conceptual Framework project for the
purpose of consistency in financial accounting standards. It also argues that the
 The Equity Theories and Financial Reporting 193

asset – liability approach is politically more easily acceptable to countries with

free market economies where the shareholder model of corporate governance is
dominant. The revenue – expense approach on the other hand is politically better
suited to countries that have more mixed economies where the stakeholder
model of corporate governance is more appropriate.

Structure of this Paper

Entity theory and proprietary theory are two perspectives of companies

subsumed under the heading equity theories. Section 2 reviews extant literature
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on the rel-evant equity theories in the English language. Section 3 summarises

the potential impact on financial reporting of applying these theories. Section 4
discusses some implications of the entity concept for the Conceptual Framework
project. Section 5 presents some general conclusions.

2. Equity Theories: A Literature Review

Equity theories were a popular topic of journal articles from the 1930s to the
1960s. According to Mattessisch (2008, pp. 29 – 30), entity theory only fully
replaced proprietary theory in the second half of the 20th century. Seidman
(1956, p. 64) on the other hand suggests ‘a full swing from an agency to an
entity back to an agency concept’. Either way, in the 1970s equity theories
started collecting dust in accounting theory textbooks or disappeared altogether
from most accounting academics and practitioners’ frame of reference.

Functions of Equity Theories

Equity theories provide different views in answer to the question whose point of
view should be taken in the accounting process of companies (Kam, 1990, p.
302). The point of view taken in the accounting and reporting process deter-
mines the perspective from which accounting transactions are analysed and the
way in which they are recorded and accounted for. According to Hendriksen and
Van Breda (1992, p. 766) equity theories interpret the economic position of the
enterprise in a different way leading to a different emphasis in disclosing the
interests of stakeholders as well as different concepts of income. More specifi-
cally, Schroeder et al. (2001, p. 305) claim that ‘Theories of equity postulate
how the balance sheet elements are related and have implications for the
definitions of both liabilities and equity.’ Zeff (1978, p. 1) uses the term
‘orientation postulate’ with regard to the point of view taken in the accounting
process because whether explicit or implicit, ‘a perspective must find expression
somewhere in the theor-etical construct’.
Lorig (1964) believed that the direct impact of equity theories is limited to
items which appear on the credit side of the balance sheet, including debt
capital, equity capital and possibly ‘the equity of the accounting entity in
 194 C. van Mourik

itself’ (p. 564). Most discussions in the literature do indeed focus on the differ-
ences of the proprietary and entity perspectives on accounting for interest, stock
and cash dividends, and income taxes, for example: Husband (1938, 1954),
Lorig (1964) and Bird et al. (1974). Other examples include discussions of
stockholder income, dividends and taxation (Seidman, 1956), capital and
retained earnings (Li, 1960a), donated fixed assets (Borth, 1948), treasury stock
(Ray, 1962), dividends (Horngren, 1957; Li, 1960b), income taxes (Li, 1961)
and government subsidies. Sprouse (1957) compares proprietary, entity,
enterprise and legal concepts of the corporation with regard to interest charges,
income taxes and dividends.
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Looking at the English language literature one gets the distinct impression
that most of the writers on this issue believe that there is only one correct answer
to the question of whose perspective should be taken in the accounting process.
Those who believe that accounting should be conducted from the shareholders’
point of view would support the proprietary theory or a variation thereof (Hat-
field, 1909; Sprague, 1913, pp. 46 – 49; Husband, 1938, 1954; Staubus, 1952,
1959). Those who believe that the accounting process should be conducted from
the business entity’s view would adhere to a form of entity theory (Gilman,
1939; Paton and Littleton, 1940; Chow, 1942; Suojanen, 1954, 1958; Seidman,
1956; Raby, 1959; Li, 1960a, 1960b, 1961, 1963). Then there are those who
have a more functional approach, and believe that accounting does not
necessarily need to take anyone’s perspective in particular. Proponents of the
functional approaches referred to by Meyer (1973) are Canning (1929), Vatter
(1947, 1962), American Accounting Association (AAA, 1957) and Gold-berg
(1965).

What Equity Theories are There?

Hendriksen and Van Breda (1992, chap. 22) distinguish between proprietary,
entity, residual, enterprise and fund theories of equity. Chatfield (1977, chap. 16)
and Schroeder et al. (2001, chap. 14) identify all of the above plus the
commander view of the firm. Meyer (1973) describes eight conceptions of the
accounting entity falling into three categories. He categorises the concepts as
follows:

The proprietary approaches: the traditional proprietary view, the residual

equity view, the equity view
The pure entity approaches: the self-equity view, the social view
The functional approaches: the AAA enterprise view, the fund view, the
commander view.

At the one extreme, profits belong to the proprietors and at the other extreme
profits belong to the business entity. The functional approaches ‘refrain from
setting up priorities among interests’ (Meyer, 1973, p. 125). This paper is not
 The Equity Theories and Financial Reporting 195

concerned with the functional approaches because they have not found much
support in the practice of business accounting.
This literature review uses the same names for the various proprietary and
entity approaches as in Meyer (1973) but classifies the equity view separately. It
will first discuss the traditional proprietary and residual equity views as the two
proprietary approaches. Then, it discusses the equity view, which Meyer (1973)
considers a proprietary approach but which is similar to entity theory as
described by, for example, Hendriksen and Van Breda (1992) and the entity
perspective as proposed by the IASB/FASB Conceptual Framework project.
Depending on the hardness of the distinction between debt and equity as
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evidenced by the treatment of transactions between a company and its share-

holders and the corresponding choice of approach to income determination, the
equity view becomes either a proprietary approach or a pure entity approach.
Finally, this literature review discusses the self-equity and enterprise (or social)
views, which like Meyer (1973) it regards as pure entity approaches.

(a) Proprietary theory

Two forms of proprietary theory are the traditional proprietary view and the
residual equity view. Proprietary theory sees the main functions of financial
accounting as the determination of the increase in the shareholders or residual
equity holders’ wealth and providing information to equity holders more than to
any other possible stakeholders.

The traditional proprietary view

The traditional proprietary perspective predates the entity perspective in
financial reporting. The former grew out of the personification of accounts
(Chatfield, 1977, pp. 219 – 223). ‘Those who believe that the accounting entity
should be per-sonified are known as the proprietary theorists, and those who
believe that the entity should not be personified are known as the entity
theorists’ (Kell, 1953, p. 42). Kell’s logic is as follows. Because under the
proprietary view transactions are analysed as to their effect on the proprietors,
one could say that in this case the accounting is personified. Under the entity
view, however, transactions are analysed as to their effect on the business entity,
and accounting is therefore not personified (Kell, 1953, p. 41).
Proprietary theory is an agency concept. In a traditional agency setting finan-
cial reports are prepared by the managers for the purpose of providing infor-
mation to the proprietors on the basis of which, the managers were held
accountable for their stewardship. Proprietors would then release the managers
of their responsibility for the results for the past period.
According to proprietary theory accounts are prepared from the viewpoint of
the proprietor(s) and are ultimately meant to measure and analyse their net worth
expressed by the accounting equation:
 196 C. van Mourik

assets − liabilities = proprietorship or net worth (1)

In the traditional proprietary view, the assets are the proprietors’ assets, and the
liabilities are the proprietors’ liabilities. According to Newlove and Garner
(1951, p. 21) under proprietary theory ‘[l]iabilities are negative assets – negative
properties, which must be sharply defined and separated in the accounting
process’. Revenues are increases in proprietorship and expenses are decreases.
Net profits, ‘the excess of revenues over expenses, accrues directly to the
owners; it represents an increase in the wealth of the proprietors’ (Hendriksen
and Van Breda, 1992, p. 770). In other words, all transactions are analysed,
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recorded and accounted for as to their immediate effect on proprietorship.

Under traditional proprietary theory the distinction between debt and equity is
absolute. This relates to the fact that proprietorship is determined as net assets.
Equity is not considered a liability of the entity to the proprietor except for
book-keeping purposes. As a consequence, under the proprietary view of the
company there are transactions or events that are considered non-reciprocal
transfers between a business and its shareholders (the proprietors). In addition,
the proprie-tary view also allows for the existence of non-reciprocal transfers
between a business and outsiders. Non-reciprocal transfers are transactions
where the business receives but does not pay or transactions where the business
pays but does not receive. APB Statement No. 4 was based on such a
classification. Examples of non-reciprocal transfers between the enterprise and
its owners include: ‘investments of resources by owners, distributions of cash or
property dividends, acquisition of treasury stock, and conversion of convertible
debt’ (APB Statement No. 4, 1970, para. 62; Bird et al., 1974, p. 237) and stock-
based compensation (Newberry, 2001). Examples of non-reciprocal transfers
between the enterprise and entities other than owners include: ‘gifts, dividends
received, loss of a negligence lawsuit, imposition of fines, and theft’ (APB
State-ment No. 4, 1970, para. 62; Bird et al., 1974, p. 237).
Proprietary theory does not allow non-reciprocal transfers to be accounted for
as exchanges from the viewpoint of the accounting entity. The reason is that
under the proprietary view ‘an enterprise cannot enter into an exchange with its
owners because it cannot obligate itself to the owners. Concomitantly, when the
enterprise distributes resources to its owners it cannot receive a release from any
obligation to them’ (Bird et al., 1974, pp. 236 – 237). In other words, under the
proprietary approach all non-reciprocal transfers are accounted for with a view
to their effect on owners’ equity. It does not allow for liabilities that are not
either debt or equity because it does not allow the entity to have equity in itself
as everything that is not debt must automatically be owners’ equity.

This hardness of the distinction between debt and equity leads to a definition
and disclosure of net income as ‘net income to shareholders’. ‘From the point of
view of the proprietor any payment to an outsider necessary to the conduct
 The Equity Theories and Financial Reporting 197

of the business is a cost or an expense’ (Chow, 1942, p. 157). Under a narrow

interpretation of the proprietary concept even cash dividends to preferred share-
holders represent an expense to the company (Sprouse, 1957, p. 376). From both
the perspectives of the stockholders and that of the company under the proprie-
tary view, cash dividends on common stock are a distribution of income to the
co-owners of the corporation (Sprouse, 1957, p. 376; Lorig, 1964, p. 570).
Because retained earnings belong to the shareholders, stock dividends on
common stock declared out of retained earnings or paid in surplus represent
merely a rearranging of shareholders’ equity.
As debts are a liability of the proprietors, interest payments are considered an
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expense. Corporate income tax however represents a taxation of the

stockholders’ income. Taxation of personal income including dividends
therefore results in double taxation. All other taxes are operating expenses.
The purpose of income determination under the proprietary view is to deter-
mine the increase in the proprietor’s wealth. Income from the proprietor’s
perspective or in the case of public limited companies the shareholder’s perspec-
tive is a net worth concept that expresses the increase in wealth using the asset –
liability approach. Some believe that assets and liabilities should therefore be
measured at current cost or fair value rather than historical cost. For example,
Hatfield (1909, p. 83) espoused valuation of inventory on a going concern basis
(i.e. current cost), and valuation of fixed assets on a historical cost basis as long
as depreciation is taken into account. Sprouse and Moonitz (1962) advo-cated
the asset – liability approach and reduced importance of the realisation prin-
ciple in the valuation of assets. See also Bird et al. (1974, p. 242). Either way, it
is extremely important to define, recognise and measure assets and liabilities
pre-cisely and reliably.
Furthermore, if income is the increase in the net assets of the owner during a
given period, ‘then all aspects that affect a change in wealth of the owner in that
given period should be included in income’ (Kam, 1990, pp. 303 – 304). In other
words, the all-inclusive concept of income (clean surplus relation) applies to the
proprietary view which means that holding gains and losses on assets and liabil-
ities as well as non-recurrent profits or losses should be included in the determi-
nation of income for the period. The proprietary theory forms the basis for the
comprehensive income concept (Hendriksen and Van Breda, 1992, p. 770)
which is advocated by the FASB and the IASB.

The residual equity view

Residual equity theory is a variation of proprietary theory which explicitly takes
into account the change in the nature of the business entity from a legal view
when a business becomes insolvent. It is also the view that is closest to the legal
approach of the company, insolvency and tax laws. Staubus, the main proponent
of the residual equity theory explains residual equity as follows:
 198 C. van Mourik

In what are thought of as normal business situations, the claimants of the

residue of assets (the holders of residual equity) are owners. [. . .] In
‘abnor-mal’ business situations, the owners’ equity, as reported in the
balance sheet, may be reduced to nothing by losses; at that point, the
general credi-tors become residual equity holders.
(Staubus, 1959, p. 8)

This theory is also referred to as the investor theory because of the idea that
‘accounting functions and financial statements should take the point of view of
investors’ (Kam, 1990, p. 313).
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The purpose of financial reporting according to Staubus (1959, p. 6) is to

‘provide any accounting information which will be of assistance in making a
choice between investing and not investing [. . .] it must be information related
to the times and amounts of the investor’s future cash receipts from the invest-
ment relationship’. Accounting and financial reporting should take the point of
view of investors because the function of financial reporting is to provide infor-
mation to suppliers of capital. The accounting equation according to the residual
equity theory is (Staubus, 1959, p. 13):

Assets − Specific Equities (= Liabilities + Preferred Stock)

= Residual Equity. (2)

In normal business situations specific equities include the claims of creditors,

long-term lenders and preferred shareholders. However, in abnormal business
circumstances ‘the equity of common stockholders may disappear and the
preferred stockholders or bond holders may become the residual equity holders’
(Hendriksen and Van Breda, 1992, p. 773). In other words, transactions are
analysed, recorded and accounted for as to their effect on the business’s residual
equity holders, usually the common shareholders.
When it comes to the non-reciprocity of external transfers, Staubus (1961, p.
61) distinguishes 18 categories of economic events, two of which are trans-
actions between the economic unit and its residual equity holders leading to
either increments (investment by proprietor or partner, issuance of common
stock) or decrements (withdrawal by proprietor, declaration of dividend on
common stock, purchase of treasure stock by a company) in a net asset item and
the residual equity. The sharp distinction between debt and equity of a going
concern becomes a sharp distinction between specific equities and residual
equity in the case of a business in liquidation. Staubus (1961, p. 62) also
distinguishes one-sided receipts and costs from two-sided receipts and costs, the
former of which always cause an increase or decrease in residual equity.

Because the residual equity holders of a business in liquidation are not the
same as the residual equity holders of a going concern the determination of
 The Equity Theories and Financial Reporting 199

income to residual equity holders must emphasise its dependent position. Under
the going concern assumption the residual equity separately disclosed in the
balance sheet is considered a buffer to all investors, except the residual equity
holders to whom it represents a measure of their claim. Investors’ interest in the
income statement focuses on the change in the residual equity (Staubus, 1959, p.
10).
The buffer function of the residual equity and the residual nature of common
stockholders’ income shift the focus of the function of accounting information to
being useful to all investors in assessing the timing and amount of their cash
receipts. Staubus (1961, p. 51) ranks asset measurement techniques in order of
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their relevance to residual equity holders as follows: (1) counting money, (2)
dis-counted future money movement, (3) net realisable value, (4) replacement
cost, (5) adjusted historical cost and (6) original money cost.
Balance sheets according to Staubus (1959, pp. 6 – 8) must give a clear
picture of the residual and other equities. The income statement’s main functions
are to account for the difference in residual equity and to enable investors to
assess the accounting entity’s ability to pay its obligations as well as its
willingness to pay cash dividends. He also stressed the importance of cash flow
information to investors. Staubus (1961, pp. 110 – 111) proposes a statement of
assets and equities stressing the difference between monetary and real assets and
specific equities (¼ debt) and a revenue and expense statement (Staubus, 1961,
p. 130) where the bottom line is recurring income to common shareholders.

The boundaries of the accounting and reporting entity under the proprietary
views
With regard to consolidation, Baker et al. (2005, p. 113) take the view that ‘the
proprietary concept results in a pro rata consolidation. The parent company con-
solidates only its proportionate share of the subsidiary’s assets and liabilities.’
Another view is expressed by Kam (1990, p. 304):

In consolidating financial statements, the parent company method is based

on the proprietary theory. The parent company is seen as ‘owning’ the
subsidiary. Minority interests, from the point of view of the ‘owner’ of the
subsidiary, represent the claims of a group of outsiders.

Minority interests should therefore be considered a liability on the balance sheet.

Schroeder et al. (2001, p. 483) do not mention the proprietary theory as a basis
for consolidation but do mention that the parent company theory evolved from
the proprietary theory of equity. However, according to Baxter and Spinney
(1975) and Baker et al. (2005) the parent company theory is somewhere between
the proprietary and entity theories. For non-consolidated long-term investments
the equity method is the appropriate approach under the proprietary theory
(Kam, 1990, p. 304; Hendriksen and Van Breda, 1992, p. 771).
 200 C. van Mourik

(b) The equity view (in between proprietary and entity)

The equity view corresponds largely to Paton and Littleton’s application of the
entity theory (1940). In this view financial accounting and reporting serve the
purpose of accountability to the suppliers of both debt and equity capital, and
must report information that is useful for their investment and resource
allocation decisions. It is an entity perspective because it sees the entity as
independent from the owners. It analyses most transactions with respect to their
effect on the entity and determines income by the revenue – expense approach.
However, it also resembles a proprietary perspective because it sees
management as the share-holders’ agents, stresses the residual nature of
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shareholders’ interests, and thus it focuses primarily on the information needs of

investors, particularly investors in equity capital and considers retained earnings
as belonging to common share-holders rather than to the entity. This appears to
be the IASB/FASB’s interpret-ation of the entity perspective.
Although the equity view considers the business to exist as an entity separate
from its founders or owners, the balance sheet equation under this view as found
in Hendriksen and Van Breda (1992, p. 771) describing the entity view is as
follows:

= + ′
assets debt capital stockholders equity capital. (3)

To the extent that there is a sharp distinction between debt and equity in the
accounting for transactions with shareholders, the equity view becomes a
proprie-tary view instead of an entity view. Such a sharp distinction is necessary
to main-tain that there can be non-reciprocal external transfers, and that the
entity cannot have equity in itself. It is also necessary if income is to be
determined using the asset – liability approach.
In his early days, Paton maintained that even income tax payments are distri-
butions in favour of the underlying equity of the state and cannot reasonably be
viewed as an expense (Paton, 1922, pp. 180 – 181, in Meyer, 1973, p. 118). In
other words, like the pure entity theorists, he considered the state to have an
underlying equity in the company. He later changed his opinion on the reason-
ableness of the government’s underlying equity and forcefully condemned
double taxation, presumably in response to what he calls ‘[h]arassment of our
businesses through punitive tax measures [. . . and] an unfriendly attitude toward
private enterprise’ (Paton, 1965, p. viii).
Inconsistencies arise especially in accounting for undistributed profits
because not all interpretations of the entity theory regard undistributed profits as
the entity’s equity in itself. Examples of those include: Gilman (1939, p. 48),
Paton and Littleton (1940, p. 105), Newlove and Garner (1951, p. 21), and Paton
(1965, chap. 2). Such inconsistencies in accounting treatments have been
identified by Husband (1938, pp. 243 – 244). Bird et al. (1974) give examples of
inconsistencies in accounting standards concerning external transfers at the
 The Equity Theories and Financial Reporting 201

time. More recent examples are discussed by Mozes (1998) and Newberry
(2001, 2003). Inconsistencies in accounting for external transfers arise from the
fact that it has been impossible to settle the debate on which mutually exclusive
concept of income must be applied in accounting standards and practice.
One concept sees income as a measure of performance, and the other views
income as an enhancement of investors’ wealth (agency perspective). See also
Newberry (2003, pp. 327 – 329). The former is expressed as the revenue –
expense approach and the latter takes the form of the asset – liability approach to
income determination. In addition, the former regards all transactions as reci-
procal transfers whereas the latter regards some transactions such as dividend
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payments, receipt of subsidies and donated assets, etc. as non-reciprocal

transfers. In the entity perspective/revenue – expense approach such transactions
are recorded as to their effect on the entity’s and the entity’s equity in itself.
Follow-ing the proprietary/asset – liability approach such transactions are
analysed, recorded and reported as to their direct effect on proprietorship. See
also Bird et al. (1974) and Newberry (2001). Regarding some transactions as
non-recipro-cal is logical within a proprietary view where debt and equity are
strictly separate, and where all transactions are analysed as to their effect on
proprietorship. On the other hand, in an entity view of the company non-
reciprocity does not exist. Not choosing between the two views of the firm and
consequently not choosing between the two approaches to income determination
leads to inconsistencies in accounting standards.
Lack of clarity and definition of the entity approach originates from two
causes. The first is the fact that in the English language literature entity theory
and proprietary theory thus far have not been correctly associated with the
revenue – expense and asset – liability approaches to income determination,
respectively. The second is the fact that some entity theorists regard retained
earnings as belonging to shareholders instead of to the entity.

(c) Entity theory

Entity theory developed out of the concept of limited liability of a company’s
shareholders. ‘Littleton considers medieval agency accounting a forerunner of
the entity theory, which in this sense predated the corporation itself’ (Chatfield,
1977, p. 224). Entity theory views the entity as ‘having a separate existence – an
arms length relationship with its owners. The relation to the owners is regarded
as not particularly different from that to the long-term creditors’ (Lorig, 1964,
p. 566).
In other words, the company’s assets belong to the entity instead of to the
shareholders. As a consequence, transactions are analysed as to their effect on
the business entity. In addition, both debt and equity capital are liabilities of the
company. Net profits under the entity theory belong to the business.

Revenue is the product of the enterprise, and the expenses are the goods
and services consumed in obtaining the revenue. Therefore, expenses are
 202 C. van Mourik

deductions from revenue, and the difference represents the corporate

income to be distributed to stockholders in the form of dividends or
reinvested in the business.
(Hendriksen and Van Breda, 1992, p. 772)

According to Kam (1990, p. 306) two versions of entity theory exist. The first
is the traditional version which sees the enterprise as operating for the benefit of
its debt and equity holders. This is the version that corresponds to what Meyer
(1973) calls the ‘equity view’ and considers a proprietary approach which has
been discussed under (b). The second version is similar to Meyer’s ‘self-equity
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view’ according to which the corporation acts in its own best interest rather than
in that of its shareholders (Meyer, 1973, p. 119; Kam, 1990, p. 306).

The self-equity view

The second and newer interpretation of the entity theory regards ‘the entity as in
business for itself and is interested in its own survival’ (Kam, 1990, p. 306). This
is the entity concept as defined by Li (1960a, 1960b, 1961, 1963, 1964). In
Meyer’s classification (1973) this would be the ‘self-equity view’ which is a
pure entity approach. It is also the name used here.
The purpose of financial accounting in this case is to meet legal requirements and
to maintain good relationships with suppliers of debt and equity capital as a means to
ensure its survival and enable the business entity to raise additional capital if
necessary (Kam, 1990, p. 306). According to Li the large corporation strives to make
profits in order to survive and maintain economic and financial competence (1960a,
pp. 258 – 259). It does not primarily strive to maximise profits (or shareholder
value) for the purpose of enriching the shareholders or max-imising the
shareholders’ utility. Attracting capital providers is necessary for the company’s
survival, but as a company goal it is secondary to its survival (Li, 1964).
Raby’s position is that from a transaction viewpoint no one really owns a
company or economic entity. Therefore, the responsibility of management as the
entity’s governing group must be first to the entity itself rather than to the
shareholders or other stakeholders (Raby, 1959, p. 454).
According to the pure entity theory accounts are prepared from the viewpoint
of the entity. The accounting equation according to the entity theory following
Paton (1922) is

assets = liabilities (4)

or

assets = equities. (5)

 The Equity Theories and Financial Reporting 203

As in the equity view, the liabilities of the enterprise include both debt and
equity. But the distinction between the two is not as pronounced as under the
proprietary views. Assets are the assets of the company in the same way that the
liabilities are the liabilities of the company.
The self-equity view is a pure form of the entity theory because it sees debt
and equity as liabilities of the business entity. The contractual obligations are
differ-ent in nature, but for a going concern in the self-equity view these
differences only matter in terms of finding the optimal mix of sources of funding
to suit its strategic, operational and financing objectives. In this view there are
no non-reciprocal external transfers. As a consequence, under the entity theory it
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is perfectly acceptable and logical for the entity to have equity in itself. In this
view retained earnings belong to the entity, not to the shareholders.
Corporate income taxes are not considered a form of double taxation.

Only in the case of the close or privately held corporation (where the cor-
poration is not really a corporation at all, but merely a convenient device
utilised by a few) does the claim of double taxation possess an important
degree of validity.
(Seidman, 1956, p. 69)

Under the self-entity view cash dividends to preferred shareholders and ordin-
ary shareholders as well as interest payments to bondholders and corporation
income tax payments represent either a distribution of income (Assets ¼ Equi-
ties) or can be viewed as an expense to the company in order to determine the
entity’s own net income in the form of retained earnings (Assets ¼ Liabilities).
Sprouse (1957, pp. 372 – 373) noted that the Asset ¼ Equities view leads to the
question what to call interest payments made to bondholders in case of corporate
losses. Similarly, when there are no profits there will be no income tax payments
but there will be interest payments and there may still be dividend payments. Li
(1961, p. 268) holds that income taxes are the cost of being a separate entity.
Stock dividends have the effect of restricting further asset dividend paying
pos-sibilities by increasing legal capital and decreasing general surplus
(Horngren, 1957, p. 381). From the perspective of the company, however, stock
dividends represent a distribution of income if they are paid out of retained
earnings (which belong to the entity), but not if they are paid out of paid-in
surplus because that represents a liability to the stockholders (Lorig, 1964, p.
571). Li (1960b, p. 679) views cash dividends as an insurance cost and stock
dividends as a form of recapitalisation designed to attract additional capital by
decreasing the stock price per share and by increasing legal capital.
Income under the self-equity view is a measure of the company’s performance
rather than an enhancement of investor wealth. This is consistent with the
revenue – expense method and accrual accounting espoused by Paton and Little-
ton (1940) to determine a business entity’s income.
 204 C. van Mourik

Many early writers associate the revenue – expense approach and accrual
accounting with historical costs. Lorig (1964, p. 572) for example considers cost
the best basis for asset valuation under the entity theory. ‘[T]he firm is not
concerned with current values because the emphasis is on the accountability of
cost to the owners and other equity holders’ (Hendriksen and Van Breda, 1992,
pp. 772 – 773). Bird et al. (1974, p. 242) state that price level adjustments are
acceptable under the entity theory. This excludes current exchange values such
as entry and exit values. The reason is that the exchanges did not take place at
current values.
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The social view/enterprise theory

The enterprise theory sees the large listed corporation as an institution with
social responsibilities. It is therefore a broader concept than the self-equity form
of entity theory. Companies’ actions affect many different stakeholders such as
stockholders, creditors, customers, employees, the government as a taxing and
regulatory authority and the public at large (Suojanen, 1954; Kam, 1990;
Hendriksen and Van Breda, 1992). Suojanen traces this institutionalisation of the
large enterprise to the separation of management and ownership leading to
increasingly large proportions of income being retained within the company to
reduce the corporation’s dependence on external financing. Large corporations
may decide to pay only ‘conventionally adequate dividends’ because this ties in
with their survival and growth objectives. In his interpretation an additional
source of funds is provided by depletion and depreciation allowances (Suojanen,
1958, pp. 56 – 57).
Suojanen proposes that large companies prepare a value added concept of
income measurement and a value added statement in addition to the normal
financial statements such as the balance sheet and income statement. ‘If the
enterprise is considered to be an institution, its operations should be assessed in
terms of its contribution to the flow of output of the community’ (Suojanen,
1954, p. 395).
Financial reporting according to the enterprise theory is to be prepared from
the perspective of the enterprise as a social institution. The accounting equation
expressing the enterprise theory according to Meyer (1973, p. 120) is

assets = investors’input contributions. (6)

‘From the point of view of all participants, all payments (disbursements of assets) to
any participant are distributions of revenue’ (Meyer, 1973, p. 120). ‘Although
stockholders have legal rights as owners, from the point of view of the enterprise
their rights are subsidiary to the organization and its survival’ (Kam, 1990, p. 315).
In this respect enterprise theory is similar to the self-equity view. As income
generated by the enterprise is analysed to measure the contribution of the enterprise
to society using the concepts developed in national income
 The Equity Theories and Financial Reporting 205

analysis, ultimately the balance sheet is secondary to output, income and value
added considerations.

[T]he enterprise theory considers that output is the relevant measure of

income in the value added statement; profitability or net income, is
measured in the income statement. It follows that the amount appearing in
the retained earnings account is imputed to the enterprise.
(Suojanen, 1954, p. 396)

For this purpose inventories and goods produced would be valued at their selling
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price. Apparently, net profit in the income statement and profit in the value added
statement do not have to correspond to each other at any given time although ‘both
methods of income determination will result in reporting the same income over time.
[. . .] [N]o basic antagonism exists between the value added and the customary
procedures of enterprise reporting’ (Suojanen, 1954, p. 397).
Value added consists of gross profits and the value added statement shows how
the value added has been distributed to employees, providers of debt and equity
capital, government, and how much profit has been retained in the enterprise for the
purpose of its expansion. The income statement allows the alignment of the interests
of all stakeholders. In the equity and self-equity views that means all investors
(stockholders and holders of long-term debt), and in the social view that means all
stakeholders including the government and all of society. In the latter case the
income statement and statement of retained earnings could take a form similar to the
one presented by Clark (1993, p. 21) or could be sup-plemented by a value added
statement. The value added statement holds manage-ment accountable for its
responsibilities to all the stakeholders in the enterprise as a social institution and not
to its stockholders or investors alone.
The social view considers profits

as the extent to which an entity has increased its assets through operations,
as the economic contribution which an entity has made to the economy in
which it operates, and as a measure of efficiency with which a business
entity has carried out its responsibilities for the economic development of
society.
(Bedford, 1965, pp. 179 – 180 quoted in Meyer, 1973, p. 120)

The boundaries of the accounting entity under the entity views

Lorig was of the opinion that according to the entity theory consolidated financial
statements present an inappropriate view because the relation between a parent and a
subsidiary company is of a debtor – creditor rather than ownership nature (1964, pp.
570 – 571). Not consolidating subsidiary companies that are under the effective
control of a parent company gives managers enormous scope for moral hazard.
Majority shareholders, current and prospective investors and
 206 C. van Mourik

long-term creditors require information about the activities and resources of the
overall economic entity. In addition, top management is generally evaluated on
the basis of the overall performance reflected in the consolidated financial state-
ments (Baker et al., 2005, p. 98 – 99).
Therefore, under the entity approach the emphasis is on the consolidated
econ-omic entity itself. Controlling and non-controlling shareholders are viewed
as two separate groups with an equity stake in the consolidated entity neither of
which is emphasised over the other. The full amounts of assets and liabilities are
combined in the consolidated balance sheet. Consolidated net income is made up
of a combined figure that is allocated between the controlling and non-
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controlling interest groups (Baker et al., 2005, pp. 115 – 116). ‘To show min-
ority interest as a liability is inconsistent with the entity approach’ (Moonitz,
1942, p. 238).

3. Equity Theories: Implications for Financial Reporting

It can be seen from the analysis of the literature above that different authors
have been able to generate significantly different approaches to financial
reporting based on variants of the two main theories. Table 1 summarises the
five approaches. In the first instance the choice of perspective orients financial
report-ing to a narrower or broader group of users. Proprietary theory primarily
con-siders the information needs of shareholders and perhaps investors in debt

Table 1. The purpose of financial reporting, balance sheet equations and income
determination

Balance Income
Company Purpose of financial accounting sheet determination
view and reporting equation approach

Proprietary/ Accountability to owners, A2D¼E Asset – liability

agency stewardship, release from
responsibility
Residual Provide useful information to A 2 Sp.Eq. Asset – liability
equity investors related to future cash ¼ RE
receipts
Equity Decision-usefulness to investors A ¼ D + E Asset – liability or
revenue – expense
Self-equity Meet legal requirements and A ¼ L or Revenue – expense
maintain good relations with A¼E
investors
Enterprise/ Meet legal requirements and A ¼ Input Revenue – expense
social maintain good relations with contrib.
investors + assessment of
contribution to society ¼ align
all the stakeholders’ interests
 The Equity Theories and Financial Reporting 207

securities, while entity theory includes the information needs of all providers of
capital or even all direct and indirect stakeholders.
Furthermore, the perspective chosen affects the determination of income and
the analysis of transactions. A proprietary view supports a view of income as
being the net change in assets and liabilities over the period. Taken to its logical
conclusion this could mean that all assets and liabilities should be measured at
current value, and the profit for the year would include value changes as well as
transactions and non-recurrent items. The entity view embraces accountability to
a wider range of stakeholders and sees financial reporting as instrumental in
aligning all their different interests. Table 2 roughly summarises some of the
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accounting implications of the proprietary and entity approaches featured in the

literature.
Two financial reporting issues that are central to the entity approach are that
the distinction between debt and equity is not fundamental to the display of
finan-cing on the balance sheet, and that payments to stakeholders can be
regarded as distributions of income. When the debt/equity divide is not critical,
there is a stronger case for an approach, such as that of a discussion paper from
the Euro-pean Financial Reporting Advisory Group (EFRAG) which suggests an
ordering of financing in terms of residual risk in bankruptcy.

4. The Conceptual Framework and Equity Theories

Following the comments on the Exposure Draft, the IASB and FASB are likely
to abandon any reference to entity and proprietary theories in the objectives of
financial reporting. In my opinion this is unfortunate because a conceptual
frame-work is an appropriate place for clarifying all the concepts and their
accounting, reporting and welfare implications before motivating a choice. The
conceptual framework project has fully embraced a decision-usefulness
perspective where income as determined by the asset – liability approach is
meant to help estimate the timing, risk and amount of cash flows to investors.
Therefore, so far in prac-tice, the conceptual framework project has been more
proprietary than entity in orientation. The real evidence will be in the accounting
standards that follow from the Conceptual Framework.

5. Conclusions

This literature review shows that the proprietary and entity theories originated at
different times in history and have not been developed continuously since. The
equity theory literature is notably undeveloped with respect to the determination
of the boundaries of the reporting entity. Another area that needs further clarifi-
cation is the distinction between capital and income as legally enforced by divi-
dend restrictions in different countries and jurisdictions. When applied logically
and transparently, the different views of the firm provide a basis for accounting
standards and practice in terms of the purpose of financial accounting and
 208 C. van Mourik

Table 2. Some accounting implications of proprietary and entity views

Transactions/ Proprietary/agency/residual
events equity Self-equity/enterprise/social
Analysed with The proprietors The entity
respect to:
Sales Sales revenues increase Sales revenues increase income
proprietorship as a measure of operating
performance
Purchases Purchase expenses decrease Purchase expenses decrease
proprietorship income as a measure of
operating performance
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Investments of Record asset at fair value and Record asset at fair value and
resources by corresponding increase in corresponding increase in
owners paid-in capital or donated paid-in capital or donated
surplus surplus
Gifts and Record asset at fair value and Record asset at zero value or
donations by corresponding increase in disclose in notes to the B/S
third parties income or retained earnings
Appreciation in Record increase in value and Supplementary disclosure in the
value of assets corresponding revaluation notes to the B/S
reserve or gain included in
income
Salary payments Disclosed as an expense Disclosed as a distribution
in income statement of income in the income
statement
Corporate income Disclosed as an expense Disclosed as a distribution
tax payments in income statement of income in the income
statement
Interest payments Disclosed as an expense Disclosed as a distribution
on debt capital in income statement of income in the income
statement
Cash dividends Distribution of income, reduces Distribution of income, reduces
retained earnings retained earnings
Stock dividends Rearrangement of shareholders’ Distribution of income if paid
stock splits equity out of retained earnings
Retained earnings Belong to the shareholders Belong to the entity
Additional Cash flow statement Value added statement
statement

reporting as well as the determination and distribution of income. However, they

can only do so within an appropriate economic, social and political context.
For accounting standard setters, be they private or public, the choice for a view of
the company must be guided by the objective of accounting regulation with regard to
social objectives and the political influence of different constituencies. The above
discussion of equity theories has hopefully demonstrated that there is always either a
proprietary (income as measure of increased shareholder and investor wealth) or an
entity perspective (income as a measure of the entity’s per-formance and
contribution) to the purpose of accounting and reporting. Choosing
 The Equity Theories and Financial Reporting 209

a perspective of the company and consequently a proprietary or entity notion of

decision-usefulness is essentially a political instead of technical decision as it
has clear consequences for the perceived importance and immediacy of
stakeholders’ financial accounting information and income distribution needs.
‘Accounting is not simply a neutral technology for economic decision-making;
it sanctions particular distributions of wealth and legitimises particular social
relationships’ (Maltby, 2000, p. 68).
The paper points out the inconsistency between the entity concept and the
asset – liability approach to income determination. The IASB/FASB Conceptual
Framework project is carried out in an international environment where market,
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financial and political institutional characteristics differ between countries.

Currently, the IASB/FASB Conceptual Framework project is from one perspec-
tive based on the entity concept but at the same time adheres to a proprietary
notion of defining performance and would base its accounting and reporting
standards on an implicit proprietary view of the firm.
Although few would dispute the value of having international accounting and
reporting standards, it is not clear that the IASB is deliberating and designing
international accounting standards and concepts in the international public inter-
est. The dominant influence of the FASB and earlier American conceptual
frame-work attempts is obvious. Is this the case because of their conceptual,
theoretical and methodological rigour, or because of the lack of an existing
alternative? Or is it perhaps because of the increasing strength of the shareholder
model of corpor-ate governance in international capital markets and the
increasing strength of cor-porate lobbyists in American, European and
international politics? An international accounting and reporting model based on
a proprietary notion of decision-usefulness and the asset – liability approach to
income determination does not take into account the different views of the
company and its role in different economic societies, and may contribute to
international ‘negative externalities’.
Giving primacy to the information needs of investors in equity and debt secu-
rities may have contributed to an externality in the form of the international
demise of the stakeholder model of corporate governance. Collusion between
management and investors in securities has increased opportunity for rent
seeking and moral hazard. Possible consequences include an exceedingly short-
term profit orientation, reduced corporate responsibility and accountability to
society, and increased income inequality within countries. Similarly, trading off
reliability for relevance may have caused another externality in the instability of
the international and national financial systems. Fair value accounting for
financial instruments without giving recognition to the role of financial account-
ing and reporting in the incentives for management to abuse off-balance sheet
entities, recognise, derecognise and leverage financial assets may have contri-
buted to irresponsible risk taking and a strong orientation towards short-term
performance indicators.
 210 C. van Mourik

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