Running head: THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 1

Case 15-2 and 16-1 Various Theories and Issues with Financial Statements
THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 2

Abstract

Presentation and measurement of financial statements can be prepared using various equity

theories. Each theory can have a different effect on how the information in the financial

statement is presented and measured. Entity, proprietary, and residual equity theories will be

discussed and evaluated by offering an income statement and balance sheet representing each

theory. Once the preparation of the financial statement has been completed, the debt-to-equity

ratio will be computed for each theory and if the ratio cannot be computed an explanation on

why it is not completed will be given. Not only are financial statements based on equity

theories, but they are also affected by the combination of businesses. When two companies are

combined, the companies must present a consolidated financial statement which combines the

financial information of both companies. Knowing what is to be reported and not reported on the

consolidated financials is critical, as it could have a direct impact on any decisions the users of

the financial statements will make. As accounting professionals, we are to present information

that provides faithful representation.

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 3

Case 15-2 and 16-1 Various Theories and Issues with Financial Statement Presentation

Entity, proprietary, and equity residual theories and “several other theories can provide a

frame of reference for the presentation and measurement of information reported in financial

statements” (Schroeder, Clark, and Cathey, 2014, p. 516). In focusing on the entity, proprietary,

and equity residual theories, an explanation of each theory will be discussed, as well as a

presentation of an income statement and balance sheet of each theory. Concerning the financial

statements, businesses that hold an interest in one another must know when to present a

consolidated financial statement. In keeping with faithful representation, accounting

professionals need to know what to include in the consolidated financial statements.

Equity is defined by SFAC No. 6 as "the residual interest in the assets of an entity that

remains after deducting its liabilities. In a business enterprise, the equity is in the ownership"

(Schroeder, Clark, and Cathey, 2014, p. 379). There are many theories on equity, the first to be

discussed is entity theory. Entity theory as an accounting equation is “assets=equities."

Ultimately what this means is "under entity theory, both creditors and stockholders provide

capital, in return for which they receive compensation. The sources of capital funding neither

affect, nor are affected by, the ongoing operations of the business enterprise. Therefore, the

question of debt versus equity financing is not relevant. Conversely, present accounting practice

presumes the amount of debt relative to equity is relevant in assessing firm value” (Clark, 1993,

p. 15). In Exhibit A, one can review how entity theory is presented when preparing an income

statement and balance sheet. It should be noted on the balance sheet liabilities, and equity are not

listed as a separate line item, they are totaled together. A debt to equity ratio can not be

completed as is it would not be relevant under this theory. As both the liabilities (debt) and

equity are equivalent or considered one and the same.

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 4

Proprietary theory views, “the net assets of the firm as belonging to the owners”

(Schroeder, Clark, and Cathey, 2014, p. 378). The accounting equation that represents this theory

is "assets-liabilities=equity." “Under the proprietary perspective, financial statements portray

the financial position of the proprietors and the changes thereof. An obligation to deliver own

equity instruments decreases the current proprietors’ interest in the entity. Consequently,

obligations to issue and deliver new shares should always be classified as liabilities” (Schmidt,

2018, p. 140). The proprietary theory is also known to be used as the “underlying elements of

the financial statements, although the AICPA, APB, and FASB have not formally described this

relationship as the elements of the financial statements" (Schroeder, Clark, and Cathey, 2014, p.

378). Under this theory, the balance sheet will record the liabilities and the equity as separate

line items with subtotals. It will also display the assets, therefore, assets less liabilities = equity.

In this case, a debt to equity ratio can be calculated, and the ratio result is displayed in Exhibit B,

which represents the income statement and balance sheet of the proprietary theory.

The last theory to be discussed is the residual equity theory, Staubus states, “It is obvious

that the residual equity concept is similar to proprietorship. However, there are three distinctions

between the concepts. One is the above-noted fact that creditors can be residual equity holders.

Another is that every accounting entity has a residual equity. In any business, non-profit

institution, government, or other organizations, there is always some person or group of persons

who have the right to benefit from the residue of assets. Finally, preferred stockholders are

normally thought of as owners and as proprietors, whereas typically, they do not qualify as

residual equity holders" (Staubus, 1959, p. 8). The accounting equation that represents the

residual equity theory is “assets-specific equities = residual equities”. “Under this approach the

residual of assets, net of claims of specific equity holders (creditors and preferred stockholders),
THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 5

accrue to residual owners” (Schroeder, Clark, and Cathey, 2014, p. 521) This means that the

common stockholders are seen as the biggest risk takers by simply investing in the company and

no matter what they are always effected by the economic change in the assets. In Exhibit C, you

will find an income statement and balance sheet based on the residual equity theory, the debt to

equity ratio is also reflected in Exhibit C, sense the residual equity theory is a concept of what

would be left to the common stockholders, the debt to equity ratio would be an important

evaluation for potential investor to make and understand. As an investor, as previously

mentioned, when businesses combine this will often result in a need to consolidate their financial

statements, which would ultimately have an impact on any decisions a potential investor would

make.

“As an accounting concept, a business combination is the bringing together of two or

more business entities into one accounting entity. A business combination occurs when a

transaction or event in which one entity (the acquirer) obtains control of one or more businesses”

(Schroeder, Clark, and Cathey, 2014, p. 551). When this occurs, consolidated financial

statements become necessary. When preparing a consolidated financial statement, the property,

plant, and equipment may need to be recording. The expenditures that should be included when

recording the property, plant, or equipment purchased would be any cost associated with the

purchase, examples of these expenditures would be the cost of the asset and any fees paid to have

the asset shipped or picked up. An example would be if a business purchased a new machine

used in manufacturing, the purchaser would capitalize the cost less any discounts applied, of the

machine and any fees paid to have it shipped to their location. Knowing this is just as important

as knowing when to prepare a consolidated financial statement.

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 6

“The purpose of consolidated financial statements is to present, primarily for the benefit

of the owners and creditors of the parent, the results of operations and the financial position of a

parent and all its subsidiaries as if the consolidated group were a single economic entity. There is

a presumption that consolidated financial statements are more meaningful than separate financial

statements and that they are usually necessary for a fair presentation when one of the entities in

the consolidated group directly or indirectly has a controlling financial interest in the other

entities” (Financial Accounting Standards Board [FASB], 2019, ASC 810-10-10). The criteria

used to determine if Bevo Corporation and Casco, Inc. would be how much ownership and

control Bevo has in Casco, Inc., per “Accounting Research Bulletin No. 51 one must consolidate

when, a parent-subsidiary relationship exist, the parent must own 51 percent or more. The

second part is that the parent exercises control over the subsidiary" (Schroeder, Clark, and

Cathey, 2014. p. 557). The companies, in this case, would prepare a consolidated financial

statement. Bevo has control over Casco, and they also paid the noncontrolling stockholder the

$75,000, which was stated to be more than twice the market value, this tells me they are also the

parent company. Treatment of the $75,000 paid by Bevo needs to be discussed to determine how

to report it on their financial statement.

Bevo advanced $75,000 to Casco, Casco then pays the noncontrolling interest in Algo,

the $75,000 so Bevo could then purchase the manufacturing division of Algo. Ultimately, Bevo

would record the $75,000 as an investment into Casco. It would not be recorded as under

accounts receivable as the case does not state the Casco is to repay or was billed for the $75,000.

As an investment, Bevo invested $75,000 in Casco, therefore Bevo would record this on their

financials as an investment into Casco. From the standpoint of the $75,000 being for property,

plant, and equipment, Bevo would not record anything here either as they technically did not
THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 7

receive title to any property, plant or equipment. As a loss, Bevo would not record a loss either,

and the $75,000 was used to form a new company for the sole purpose of buying out the

noncontrolling interest in the Algo company. The goal to obtain Algo’s manufacturing division

was obtained by investing the $75,000 into Casco so that Casco could buy out the noncontrolling

interest in Algo. Simply put of the four examples given, Bevo recording this transaction as an

investment would be best suited on their financial statements.

"In accounting for business combinations, it is essential to recall that consistent with

qualitative characteristic of faithful representation, fair reporting of the results of economic

events is the essences of the accounting process. Financial statements that report the results of a

business combination should not be biased in favor of any group and must be based on the

underlying substance of economic events" (Schroeder, Clark, and Cathey, 2014, p. 551). In the

cases presented, one has learned of the various equity theories and how the combinations of

businesses are to be reported. In accounting and as professionals, it is their responsibility to

provide relevant and reliable financial statements to the end-user. "Trust in the Lord and do

good; dwell in the land and enjoy safe pasture. Delight yourself in the Lord, and he will give you

the desires of your heart" (Life Application Bible, Ps. 37:3-4).

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 8

Exhibit A

Entity Theory

Case 15- 2
Entity Theory - Balance Sheet
Drake Company
December 31, 2014

Assets
Current Assets $ 87,000.00
Non-Current Assets $ 186,000.00
Total Assets $ 273,000.00

Equity
Current Liabilities $ 19,000.00
Bonds Payable $ 100,000.00
Preferred Stock $ 20,000.00
Common Stock $ 50,000.00
Paid-in Capital in Excess of Par $ 48,000.00
Retained Earnings $ 36,000.00
Total Equity $ 273,000.00

Debt to Equity Ratio : Entity Theory would not complete the ratio

Case 15- 2
Entity Theory - Income Statement
Drake Company
December 31, 2014

Sales
Revenues $ 450,000.00
Expenses
Less:Cost of Goods Sold $ (220,000.00)
Less: Operating Expenses $ (64,000.00)
Net Income: $ 166,000.00
THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 9

Exhibit B

Proprietary Theory

Case 15- 2
Proprietary Theory - Balance Sheet
Drake Company
December 31, 2014

Assets
Current Assets $ 87,000.00
Non-Current Assets $ 186,000.00
Total Assets $ 273,000.00

Liabilities
Current Liabilities $ 19,000.00
Bonds Payable $ 100,000.00
Total Liabilities $ 119,000.00
Net Assets: $ 154,000.00

Equity
Preferred Stock $ 20,000.00
Common Stock $ 50,000.00
Paid-in Capital in Excess of Par $ 48,000.00
Retained Earnings $ 36,000.00
Total Equity $ 154,000.00

Debt to Equity Ratio : 0.77 Debt = 119,000/ Equity 154,000

Case 15- 2
Proprietary Theory - Income Statement
Drake Company
December 31, 2014

Sales
Revenues $ 450,000.00
Expenses
Less:Cost of Goods Sold $ (220,000.00)
Less: Operating Expenses $ (64,000.00)
Net Income: $ 166,000.00

Earnings per Common and Preferred Shares: $ 31.92

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 10

Exhibit C

Residual Equity Theory

Case 15- 2
Residual Equity Theory - Balance Sheet
Drake Company
December 31, 2014

Assets
Current Assets $ 87,000.00
Non-Current Assets $ 186,000.00
Total Assets $ 273,000.00

Liabilities
Current Liabilities $ 19,000.00
Bonds Payable $ 100,000.00
Total Liabilities $ 119,000.00
Preferred Stock $ 20,000.00

Total Net Assets less liabilities and preferred equity $ 134,000.00

Equity
Common Stock $ 50,000.00
Paid-in Capital in Excess of Par $ 48,000.00
Retained Earnings $ 36,000.00
Total Equity $ 134,000.00

Debt to Equity Ratio : 1.04 Debt = 139,000/ Equity 134,000

Case 15- 2
Residual Equity Theory - Income Statement
Drake Company
December 31, 2014

Sales
Revenues $ 450,000.00
Expenses
Less:Cost of Goods Sold $ (220,000.00)
Less: Operating Expenses $ (64,000.00)
Net Income: $ 166,000.00

Earnings per Common Share: $ 33.20

THEORIES OF EQUITY/FINANCIAL REPORTING: VARIOUS ISSUES 11

References

Clark, M. W. (1993). Entity Theory, Modern Capital Structure Theory, and the Distinction

Between Debt and Equity. Accounting Horizons, 7(3), 14–31. Retrieved from

http://faculty.etsu.edu/POINTER/clark_m_1.pdf

Financial Accounting Standards Board (FASB). (2019) Consolidation

(ASC 810) Retrieved from https://asc.fasb.org/section&trid=2197487

Life Application Study Bible NIV. (1997). Carol Stream IL 60188: Tyndale House Publishers,

Inc.

Schroeder, R. G., Clark, M., & Cathey, J. M. (2014). Financial Accounting Theory and Analysis:

Text and Cases (11th ed.). Hoboken, NJ: Wiley.

Schmidt, M. (2018). A Note on the Proprietary and Entity Perspectives in Financial Statements:

The Implications for two Current Controversial Issues. Accounting in Europe, 15(1), 1

34–147. https://doi.org/10.1080/17449480.2018.1430368

Staubus, G. J. (1959). The Residual Equity Point of View in Accounting. Accounting

Review, 34(1), 3. Retrieved from

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