Distinguish between proprietary theory and entity theory. Include descriptions of the balance sheet equation used by each and how income is computed.

Question

What will be an ideal response?

Answer 1

ANSWER:
Proprietary theory assumes that the owners and the firm are virtually identical. This theory is descriptive of economies made up largely of the small owner-operated firms that existed prior the Industrial Revolution. More recently, it has been applied to large oligopolistic firms in an attempt to bring the absentee owner to center stage when viewing the business enterprise. These absentee ownership claims were legitimized by measuring profit available for distribution to owners rather than the notion that earnings—and capital—belong to the corporation itself. Under proprietary theory, the assets belong to the firm’s owners, the liabilities are their obligations, and ownership equities accrue to the owners. The balance sheet equation is “Total assets - Total liabilities = Owners’ Equities.” Income represents the owners’ increase in both net assets and owners’ equities arising from operations during the period.

Entity theory assumes the firm and its owners are separate beings. The assets belong to the firm itself; both liability and equity holders are investors in those assets with different rights and claims against them. The balance sheet equation is “Total Assets = Total Equities (including liabilities).” Under orthodox entity theory, stockholders have rights relative to receiving dividends when declared, voting at the annual corporate meeting, and sharing in net assets after all other claims have been met. Owners’ equity accounts do not represent their interest as owners but simply their claims as equity holders. Similarly, net income does not belong to the owners although the amount is credited to the claims of equity holders after all other claims have been satisfied. Income does not belong to capital providers until dividends are declared or interest becomes due. In measuring income, both interest and dividends represent distribution of income to providers of capital. Hence, both are treated the same and neither is a deduction from income.

If the entity theory were taken to its logical conclusion, the owners’ equity accounts would belong unequivocally to the firm, despite the presence of stockholder claims. Also, income would belong to the firm itself and, in turn, interest and dividends would both be deductions in calculating it.