ACCT6375

Accounting Theory
Week 6
Liabilities and Owner’s Equity
 The entire slide
comes from:
Accounting Theory 7 th
edition, chapter 8.
Image(s)
Area
 Learning Outcome
• Explain the underlying theoretical concept behind
accounting practices.
• Describe positive accounting theory, capital market
and understand the role of theories as abstractions
of reality and their application in real world
phenomena.
 Outline
• Proprietary and Entity Theory
• Liabilities Defined
• Liability Measurement
 SUB TOPIC:
PROPRIETARY AND ENTITY THEORY
 Proprietary and entity theory

• Proprietary theory is based on the idea that the owner is

the centre of attention
– accounting is done with the owners’ interests in mind
• Entity theory focuses on the firm as the centre of
attention
 Proprietary theory

• Proprietorship = net worth of owners = capital

• P=A–L
• The objective of accounting is to determine the net worth
of the owners
• Profit is the increase in net worth
– includes operating profit
– includes changes in the values of assets
 Proprietary theory

• Present accounting is largely based on this theory

– dividends
– salaries
– equity accounting
– consolidation accounting
• Has a financial view of capital
– emphasis on the financial investment of the owners and
changes in owners’ wealth
 Proprietary theory

• With the advent of the company the theory has proved

inadequate as a basis for explaining company accounting
– developed when businesses were smaller
– a company is separate from its owners
– a company is a legal entity in its own right
– shareholders rely on managers for information
– no longer so relevant
 Entity theory

• Inadequacies in proprietary theory led to the

entity theory
• Formulated to address separate legal status of
company
 Entity theory

• The company is viewed as a separate entity

with its own identity
– separation of owners and managers
– accounting views the entity as an operating unit
– accounting principles and procedures not
formulated in terms of an ownership interest
– can also be applied in proprietorships,
partnerships and not-for-profit organisations
 Entity theory

• The objective of accounting may be either

stewardship or accountability
– entity seen as being in business for itself
– interested in its own survival
– sees owners as outsiders
– reports to owners to meet legal requirements and
maintain good relationships with them
 Entity theory

• Focuses on the assets

• Assets are resources controlled by the entity
• Liabilities are obligations of the entity
• Profit increases net assets and accrues to the
entity
• The owners only have a residual claim on the
net assets of the entity
 Entity theory

• Both proprietary and entity theories are still

influential in practice
– entity theory
• conventional accounting theory based on it
• financial reports reflect it
– proprietary theory
• interest charges are an expense
• dividends are a distribution of profit
SUB TOPIC: LIABILITIES DEFINED
 Liabilities defined

IASB Framework definition of liabilities:

A present obligation of the entity arising from
past events, the settlement of which is
expected to result in an outflow from the
entity of resources embodying economic
benefits
 Present obligation

• The actual sacrifices are yet to be made

• Obligation is already present
• Planned obligation included if to an external
party
• Legal enforceability
• Settlement of liability in various ways
• Equitable and constructive obligations
 Past transaction

• A past transaction (or event) ensures that only

present liabilities are recorded and not future
ones
• What kind of past transaction or event is
acceptable?
– wholly executory contracts
 Liability recognition

Recognition criteria:
• Reliance on the law
– legal enforceability
• Determination of the economic substance of
the event
– ‘real’ obligation
 Liability recognition

Recognition criteria:
• Ability to measure the value of the liability
– normally the nominal amount
– if period longer than 12-months, based on the
present value of expected future cash flows
• Use of the conservatism principle
– at what point is the entity too conservative
 IASB Framework

• A liability should be recognised if

– it is probable that any future economic benefit
associated with the items will flow to or from the
entity; and
– the item has a cost or value that can be measured
with reliability
 IASB Framework

• What does probable mean?

• What is meant by reliable measurement?
SUB TOPIC: LIABILITY
MEASUREMENT
 Liability measurement

• The Framework provides little guidance about how to measure

liabilities
• A number of different measurement bases may be used
• Under IFRS, historical cost is the most common
• Fair value measurement is more commonly being used
– leases
– financial instruments
– share based payments
– business combinations
 Employee benefits – pension
(superannuation) plans

• Unfunded commitments
– equitable obligations
 Provisions and contingencies

• Provisions and contingencies occur where there is

a blurring between present and future obligations
• Liabilities and provisions are recognised only
when there is a present obligation, it is probable
and it can be reliably measured
• Contingent liabilities do not meet these criteria
– notes
 Owners’ equity

• Framework defines equity as

– the residual interest in the assets of the entity
after deduction of its liabilities
• Owners’ equity is a residual claim
 Owners’ equity

Essential features
• Rights of the parties
• Economic substance of the arrangement
 Concept of capital

• Influenced by legal prescriptions

– capital maintenance
• Financial capital
– invested money or invested purchasing power
• Physical capital
– the productive capacity of the entity
• Capital can be measured on either a nominal
dollar or purchasing power (‘real’) scale
 Classifications within owners’ equity

• The distinction between contributed and

earned capital is useful
– retained earnings
– not all transactions fit nicely into categories
• share dividends
SUB TOPIC: CHALLENGES FOR
STANDARDS SETTERS
 Challenges for standard setters

• IASB has several projects which will affect the

definition, recognition and measurement of
liabilities
– debt versus equity distinction
– extinguishing debt
– employee shares (share-based payment)
SUB TOPIC: ISSUES FOR AUDITOR
 Issues for auditors

• The completeness of liabilities recognised on the

balance sheet and the note disclosures about
contingencies and other obligations are major
issues for auditors
– evidence, timing, cut off
– concealment and understatement
– going concern
– overstatement - provisions
– reasonableness of fair values
 Summary

• There two competing theories that help explain accounting

practice - proprietary and entity theories
• There are definitions for both liabilities and equity
• There are recognition criteria for both liabilities and equity
• There are various measurement practices used in relation to
liabilities and equity
• There are challenging issues for standard setters and
auditors
 Key terms and concepts

• Liabilities
• Owners’ equity
• Proprietary theory
• Entity theory
• Definitions
• Recognition criteria – probable, reliable
• Present obligation
• Past transaction
• Measurement and fair value
• Provisions and contingencies
• Rights of the parties
• Economic substance
• Concept of capital
• Debt versus equity, extinguishing debt and employee shares
• Issues for auditors
Thank You
37
 Reference
• Godfey, J., Hodgson, A., Tarca, A., Hamilton, J.
& Holmes, S. (2010). Accounting Theory 7th
edition chapter 8. Wiley. Brisbane.
Thank You