Discuss the residual equity theory and its assumptions. Include a description of the accounting equation used and how income would be computed.

Question

What will be an ideal response?

Answer 1

ANSWER:
The residual equity theory is a variant of both proprietary and entity theory. The residual equity holders are that group of equity claimants whose rights are superseded by all other claimants, the common stockholders. Common stockholders are the ultimate risk takers within an enterprise. Their interest in the firm serves as a buffer or protector for all groups with prior claims on the firm, such as preferred stockholders and bond owners. The underlying assumption of the residual equity theory is that information appropriate for decision-making purposes, such as that helpful in predicting cash flows, must be supplied to the residual equity holders. The balance sheet equation under this approach would be “Total Assets - Total Specific Equities (including liabilities and preferred stock) = Residual Equity.” Although the assets are still owned by the firm, they are held in a trust type of arrangement and management’s objective is maximization of the value of the residual equity. Income accrues to the residual equity holders after all other claims have been met. Interest and preferred dividends (but not common dividends) would be deductions in arriving at income.