The Proprietary vs the Entity Theory - Essay Example

? THE PROPRIETARY VS THE ENTITY THEORY This discussion seeks to answer - How a selected accounting theory has contributed to the development of existing accounting practice? This would show how an accounting theory such as proprietary theory or entity theory could help in the development of accounting practice. The discussion focuses on the strengths, weaknesses and limitations of the proprietary and entity theories. The discussion also places these theories within the current accounting frameworks which exist in practice in the UK. Two of the concepts that are widely held and considered within accounting practice are the proprietary and the entity concepts. The proprietary theory suggests that business or other organizations tend to belong to one or more persons thought of as proprietors or owners, and their views are reflected in the accounting process used by the business. So assets of the business are considered as assets of the proprietors and their liabilities are considered as their liabilities. The balance sheet equation would thus be "Assets—Liabilities = Proprietorship.'' (Riahi-B, 2004) The stockholders are seen as individuals joined in owning a business and a corporation is thus not seen as fundamentally different from a sole proprietorship. The corporation is seen as a "device of a representative nature by means of which the association's business affairs may be conveniently administered with certain legal privileges and within certain legal limitations."' (Riahi-B, 2004) Using a proprietary theory, in accounting practice, the emphasis is on the proprietor's equity and the proprietors' net income and changes in income or other aspects of the proprietorship. The retained earnings also belong to the proprietors. However stockholders are distinct from creditors and the distinction is based on proprietorship as creditors may not be proprietors but stockholders are usually proprietors so proprietors in a business organisation include all stockholders. Usually most accountants consider shareholders as owners and proprietorship is more easily determined in a small business enterprise although proprietorships could range from individual proprietorships for each, a partnership, or corporation. Some features that proprietors seek are high profit (including minimizing taxes), little risk, continued existence, ease of sale of interests, etc (Lewis-Pendrill, accessed 2011; Riahi-B, 2004). One criticism of proprietorship is that it is not possible to determine the profits of individual common stockholders of a corporation and corporate profit when equated with personal gain of proprietors defines the proprietary concept yet there isn't much support to this. The stockholders' share of increase in proprietorship through residual equity shows the applicability of the proprietary concept and stockholder control. Yet stockholders have to be responsive to the wishes of equity interests as they are the owners and have greater control and bear greater risks and rights of residual equity (Riahi-B, 2004, Mourik, 2010). Usually large businesses have stock option plans for their executives along with incentive bonus plans. This has resulted in management interests to increase profits and identify interests with those of proprietors (Hendriksen and Breda, 1992). The entity concept suggests that a business or unit accounted for or considered within accounting practice must be considered as entirely separate from shareholders and owners of the business. Thus the business is seen as not an ownership but a separate entity. The entity is thus seen as having a separate and distinct existence from its owners and the owners are almost seen as long term creditors. The balance sheet equation suggests that " Assets=Equities." (Mourik, 2010) However despite the simplicity of the concept , the entity theory faces some confusion and uncertainty and the nature of equities is not completely clear. There are also difference of opinions and although creditors and owners are seen as distinct, accounting processes treat them similarly due to the similar nature of their financing. Both are looking to derive profits, have invested in the business and seek returns. Thus in terms of accounting practice, both may be similar and proprietors are also regarded as creditors and shareholders are regarded as owners. It is obvious from the entity concept, there seems to be universal agreement that the income of a corporation is not income of the stockholders and income becomes public only when dividends are declared. It has also been suggested that "business capital supplied by stockholders to the corporation does not represent the equity of the former, but rather that of the latter." Retained earnings and profits could represent the corporation and measure equity as available to the corporation. In an incorporated business the following facts are considered within the entity theory The stockholders have practically the same relation to the corporation as the bondholders. They do not own the profit made by the company. They are mere investors in the corporation with practically no say in its operation. The properties are owned by the corporation, not the stockholders. The accounting and financial reporting are for all interested parties, including the entity's administration. They are not intended specifically for the stockholders. (Mourik, 2010) This would suggest that within an entity concept, stockholders are closer to creditors than owners although within the entity concept, stockholders and long term creditors are treated similarly and according to the entity theory, all accounting entities, owners, partners and sole proprietors also hold such a creditor relationship to their respective business enterprises(Lewis-Pendrill, accessed 2011). The main criticism of the entity concept relates to the accounting decisions or principles that follow from dealing with the accounting problems by considering the business as an entity of its own (Lewis-Pendrill, accessed 2011). So from a practical accounting viewpoint, the proprietorship theory would be more feasible as there are definite aims and objectives involved. In the entity concept, another criticism is that the creditor relationship between accounting entities and owners could be unrealistic and thus there is no proper basis on which to build the theoretical accounting structure or framework. The common stockholders are not considered creditors otherwise it would be necessary to pay them off which is not the case if the company does not profit. This is again not in conformity with the entity theory. Mourik (2010) discussed the accounting literature on proprietary and entity theory to gain better insights on the implications of these two types of theories and concepts in financial accounting and reporting. Mourik suggested that there is a lack of agreement on the definition and accounting implications of the various equity theories, including definitions and accounting implications of entity and proprietary theories. The accounting literature as available according to Mourik (2010) however indicates clear differences between pure proprietary and pure entity perspectives of a firm. This would show how accounting theories could influence practice and how differences in accounting theories could inform practice. The distinction between debt and equity and its accounting implications for analysis shows how definition, determination and distribution of income could be related to accounting theories. Mourik (2010) suggested that the entity perspective of a company as taken within the entity theory of accounting could be theoretically irreconcilable within the asset-liability approach to determining income. There is also an implicit perspective to financial reporting with the net results being inconsistency in accounting standards. The proprietary theory and proprietary views of the company in which the company is seen as belonging to owners or proprietors would suggest that the purpose of income determination would be measuring the increase in wealth of owners and this is done by the asset-liability approach that affects the net income of shareholders. Decision-usefulness as proprietary notion gives priority to information and needs of investors and also other bond and debt security holders or creditors. Proprietary notion of accounting practice have these related issues of considering owners or creditors although there seems to be some inconsistencies with interpretations related to entity theory as shown by theorists. Entity views of firms regard that income determination provides a measure of performance of the company using the revenue -expense model as the company survival tool along with stakeholder interests. Liabilities in entity theory does not distinguish debt from equity as all of it is seen as equity (Hendriksen and Breda, 1992). The expenditures to satisfy all stakeholders are shown as distribution of enterprise income and retained earnings are seen as belonging to the company. Within the entity theory, priority is given to the information needs of the entity's survival or the company's survival and coordination with all stakeholders, considering their interests. Entity theory also has to ideally consider the firm's contribution, transparency in dealings and maintain accountability to government, people and society as a survival tool. According to proprietary theory, in business and accounting practice, accounts are prepared from the viewpoint of the proprietor(s) sp this sort of theory would be most practical and in accordance with practice. Proprietary theories are ultimately meant to measure and analyse net-worths of proprietors expressed by accounting equations. This shows the contributions or roles of proprietors and owners in a firm. The equation is given as assets - liabilities = proprietorship or net worth (1) 9Hendriksen and Breda, 1992; Mourik, 2010). Within accounting practice such proprietorship theory would help determine net worths of individual owners and proprietors although this may not be as good or efficient a tool in determining the business performance as an entity which the entity concept is more capable of doing. According to Newlove and Garner (1951, p. 21) within the proprietary theory ‘[l]iabilities are negative assets – negative properties, which must be sharply defined and separated in the accounting process’. The Entity theory has been developed out of the concept of limited liability of a company’s shareholders. This means that shareholders have limited liabilities and unlike the proprietorship concept does not require liabilities to be sharply defined and separated in the accounting process. This theory keeps the creditors, investors or shareholders as distinct and separate from risks and ownership thus making the accounting process more firm or company based rather than proprietor based. As expressed by Lorig, Entity theory views the entity as ‘having a separate existence – an arms length relationship with its owners. The relation to the owners is regarded as not particularly different from that to the long-term creditors’ (Lorig, 1964, p. 566). Since in the entity theory, the company assets belong to the company instead of shareholders or the owners, all transactions are analysed in accordance to their effects on the business as an entity. Although debt and equity capital are considered as liabilities of the company. This could be an essential successful framework for business and would have advantages as the owners keep themselves separate from business performance and consequently its risks. Existing accounting practice could in fact consider the proprietorship theory more practical but the entity theory would be more advantageous and cut off or undermine individual risks. However as already mentioned in order to keep accounting practice smooth and reliable, it would be necessary to use all methods of transparency and accountability within entity theory. In conclusion both proprietorship and entity theories would have their advantages and disadvantages but the most widely used theory would have to be more practical not only in terms of shareholder perception but also in terms of accounting practice. Bibliography: Alexander David , Anne Britton, Ann Jorissen, International Financial Reporting and Analysis, Cengage learning Corporate Governance and Accountability, Jill Solomon, Wiley and Sons Lewis Richard, Pendrill David (2011) Advanced Financial Accounting, , Prentice Hall Anon, EBSCOhost: STANDARD SETTING AND THE ENTITY-- PROPRIETARY DEBATE. Available at: http://0-web.ebscohost.com.emu.londonmet.ac.uk/[Accessed November 26, 2011a]. Anon, The new approach to business combination introduced by the revised IFRS 3 and the revised IAS 27. Available at: http://www.rsmfarrellgrantsparks.ie/wp-content/uploads/2011/04/IFRS3-and-the-revised-IAS-27.pdf Clark, M.W., 1993. Entity theory, modern capital structure theory, and the distinction between debt and equity. Accounting Horizons, 7(3), pp.14-31. Hendriksen, E. S. and Van Breda, M. F. (1992) Accounting Theory, 5th. edn (Homewood and Boston: Richard D. Irwin). Lorig, A., 1964. Some basic concepts of accounting and their implications. JSTOR, 39(3), pp.563-573. Morgan, R. et al., An Explanation of F A S B Statement NO.160. , Tennessee CPA Journal(Jan/Feb). Available at: http://www.rsmfarrellgrantsparks.ie/wp-content/uploads/2011/04/IFRS3-and-the-revised-IAS-27.pdf [Accessed November 26, 2011]. Newlove, G. H. and Garner, P. S. 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