TUTORIAL 2 (WEEK 3)

Question 1

With respect to the proprietary theory:

(a) What is the objective of the firm?

(a) The firm essentially is the proprietor. The firm is simply the proprietor’s instrument
to achieve his or her purpose, which is to increase his or her wealth. Income
represents the increase in the wealth of the proprietor in a given period.

(b) How important is the concept of ‘stewardship’?

(b) Stewardship is relatively unimportant, because accountability to outside parties is
not critical. The proprietor is, in effect, the firm, and therefore is in a privileged
position to know what is happening. Liabilities are usually short term, and therefore
there is no need to give a continual accounting to creditors.

(c) What is the relationship between assets/liabilities and the owner?

(c) The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner.
This shows that there is no separation between the firm and the owner. In the
accounting equation, P stands for the net worth of the owner.
A–L=P

(d) How would you define revenues, expenses, profit?

(d) Revenue is the increase in proprietorship;
Expense is the decrease in proprietorship; and
Profit is the net effect of proprietorship, excluding additional investments and
withdrawals by the owner.
Revenue and expense accounts are truly subsidiary accounts of P.
 They have the same algebraic characteristic as ‘net worth’ — increases in net
worth are credits and decreases in net worth are debits.
 The proprietary theory focuses on P in viewing income. Revenues and
expenses are caused by the decisions and actions of the proprietor. The
profit of the firm belongs to the proprietor and that is why P is affected in
the accounting equation.
(e) What are three effects on current practice?

(e) The following are examples of the effect of the proprietary theory on accounting
practice:
 Dividends paid are a distribution of earnings, not an expense; and interest
charges are an expense.
 In a sole proprietorship or partnership, salaries to owners who work in the
firm are not considered an expense of the business. The reason is that the
firm and the owner are not separate entities; they are the same.
 The equity method for long-term investments focuses on the proprietary
interest of the investor company in the invested company.
 The parent company theory for consolidating financial statements views the
parent as ‘owning’ the subsidiary. Non-controlling interest is considered
an ‘outside’ claim, and logically should therefore be a liability on the
consolidated statement of financial position.
 The pooling of interests method for business combinations emphasises the
uniting (pooling) of the owners’ interests of the two combining
companies.
 Common terms used reveal the proprietary interests of owners are: book
value per share, earnings per share and income to shareholders.
 The use of the consumer price index for general price level adjustments
shows that the ‘consumer desires’ of owners are considered.
 The financial capital view is pertinent to owners.

(f) What are the theory’s limitations?

(f) The proprietary theory does not accord with the realities of the large corporation.
 The law recognises the corporation as a separate entity, distinct from the
owners. The corporation — not the shareholders — owns (controls) the
assets, and is liable for the debts.
 For the large corporation, withdrawals of cash or other assets by shareholders
cannot be made without running afoul of the law. This shows that the
ownership rights of shareholders are limited.
 Accountability to shareholders is significant; otherwise, shareholders have no
knowledge of the status and operations of the business.
The assumptions of the proprietary theory are not relevant to the shareholders of large
firms.