SUMMARY

ACCOUNTING THEORY
(SUBJECT CODE: ECAU601401)

Chapter 8
Liabilities and Owner’s Equity
(Godfrey et.al. Accounting Theory 7th Ed)

Lecturer:
Mrs.SitiNuryanah, S.E., M.S.M., M.Bus.Acc., Ph.D.

Group Member
1. Eggie Auliya Husna 1706105246
2. Fendhi Birowo 1706105290
3. M. Avisena 1406612275
4. Yolanda Tamara 1506736064

SALEMBA EXTENSION CLASS

ACCOUNTING PROGRAM
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITY OF INDONESIA
YEAR 2018
MINDMAP FOR CHAPTER 8

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 CHAPTER 8
LIABILITIES AND OWNER’S EQUITY

PROPRIETARY THEORY AND ENTITY THEORY

Proprietary theory is based on the idea that the proprietor (or owner) is the centre of attention.
Under this view, all accounting concepts, procedures and rules are formulated with the
owner’s interest in mind. In contrast, entity theory proposes that the business is a separate
entity and accounting records the transactions of the entity.
Proprietary Theory
Proprietorship represents the net worth of the business and can be represented in the
accounting equation:
P=A–L
Where proprietorship (or owner’s equity) is equal to assets less liabilities. P represents the net
worth of the owner of the business. As Sprague states:
The balance sheet of proprietorship is a summing-up at some particular time of all the
elements which constitute the wealth of some person or collection of persons . . .
The whole purpose of the business struggle is increase of wealth, that is, increase of
proprietorship.
Assets belong to the proprietor and liabilities are the obligations of the proprietor. In this
light, we can see that the objective of accounting is to determine the net worth of the owner.
The economic theory of the firm takes a proprietary view, with its emphasis on the role of the
entrepreneur-owner. The concept of income, which increases net worth, is seen as a return for
‘enterpreneurship’.
Income is earned, and expenses are incurred, because of the decisions and actions of the
owner or the owner’s representative. Income and expense accounts are subsidiary accounts of
P, which are temporarily segregated for the purpose of determining the profit of the owner.
Income is the increase in proprietorship; expense is the decrease in proprietorship. Net
income is, therefore, the increase in the wealth of the owner from business operations during
a given period. If this is what income represents, then it should include all aspects that affect
the change in the owner’s wealth in that given period. Thus, change in net worth derives from
income-generating activities as well as changes in value of assets.
To a large extent, present accounting practice is based on the proprietary theory:
 Dividends  considered a distribution of profits rather than expenses because they are
payments to owners
 Interest on Debt and Income Taxes  considered expenses because they reduce the
owner’s wealth
 Salaries  for a sole proprietorship and partnership, salaries paid to owners who work in
the business are not considered an expense, because the owner and the firm are the same
entity and one cannot pay oneself and deduct that as an expense
 Equity Accounting  the equity method for long term investments recognises the
ownership or proprietary interest of the investor company. It therefore authorises the
investor company to record as profit its percentage share of the investee’s profit.

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 Consolidation Accounting  the parent company method is based on the proprietary
theory. The parent company is seen as “owning” the subsidiary. Minority interest, from
the point of view of the “owner” of the subsidiary, represents the claims of a group of
outsiders. The extent of the minority interest is shown as a reduction in proprietorship.
A financial capital rather than a physical capital view is appropriate under proprietary theory.
The former emphasises the financial investment of the owners, whereas the latter focuses on
the firm’s ability to maintain its physical operating level without any regard to ownership
claims. The proprietary view sees no distinction between the assets of the proprietor and the
assets of the entity.
With the advent of the company the theory has proved inadequate as a basis for explaining
company accounting:
 Developed when business were smaller
 A company is separate from its owner
 A company is a legal entity in its own right
 Shareholders rely on managers for information
 No longer so relevant

Entity Theory
The entity theory was formulated in response to the shortcomings of the proprietary view
concerning the separate legal status of a company. The theory starts with the fact that the
company is separate entity with its own identity. The theory goes beyond the “accounting
entity assumption” regarding the separation of business and personal affairs. Martin outlined
the two related assumptions embodied in the notion of an accounting entity:
 Separation  for accounting purposes, the enterprise is separated from its owners.
 Viewpoint  accounting procedures are conducted from the viewpoint of the entity.
Although the entity theory is especially suitable for corporate accounting, supporters believe
that it can be applied to proprietorships, partnerships, and even not-for-profit organisations,
providing:
 The accounts and transactions are classified and analysed from the point of view of the
entity as an operating unit, and
 Accounting principles and procedures are not formulated in terms of a single interest,
such as proprietorship.
When entity perspective is taken, the objective of accounting may be either stewardship or
accountability:
 Entity seen as being in business for itself
 Interested in its own survival
 See owners as outsiders
 Reports to owners to meet legal requirements and maintain good relationships with them
Under the entity theory, the focus of accounting equation is assets and equities. Net worth of
the proprietor is not a meaningful concept, because the entity is the centre of attention.
Owners and creditors are seen simply as equityholders, providers of funds. The accounting
equation thus:
Assets = Equities

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The assets belong to the firm and the liabilities are the obligations of the firm, not the owners.
Under the entity view, income is defined as the inflow of assets due to the transactions
undertaken by the firm and expense relates to the cost of the assets and other service used up
by the firm to create the income for the period. Expenses reduce the worth of the entity’s
assets.

LIABILITIES DEFINED
The IASB Framework para. 49 (b) defines a liability as a present obligation 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
The requirement that an obligation must be the result of a past event ensures that only
present liabilities are recorded and not future ones. As in the maintenance example, the
past event of signing the contract for maintenance give rise to the present liability.
Wholly excecutory contracts provide an interesting case for interpreting the term ‘past
event’.
Liability Recognition
Once the definition of liability is met, accountants need rules to determine if it should be
recognised. The type of rules which have been applied in the past are similar to those applied
to the recognition of assets. They include:
 Reliance on the law
 Determination of the economic substance of the event
 Ability to measure the value of liability
 Use of the conservatism principle
IASB Framework
The IASB Framework provides guidance in relation to the recognition of balance sheet and
income statements elements. Para. 82 states that an item that meets the definition of an
element should be recognised if:
a. It is probable that any future economic benefit associated with the items will flow to or
from the entity, and
b. The item has a cost or value that can be measured with reliability
Para. 91 gives additional specific guidance. It states that a liability is recognised in the
balance sheet when it is probable that an outflow of resources embodying economic benefits
will result from the settlement of a present obligation and the amount at which the settlement
will take place can be measured reliably. What is meant by reliable measurement? The
framework states that reliable measurement is that which is “free from material error and

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bias”; further, that an item is measured so that it “faithfully represents” what it purports to
represent (Para. 31).

LIABILITY MEASUREMENT
Employee Benefits – Pension (Superannuation) Plans
Pension plans can be regarded as a promise by the entity to provide pensions to employees in
return for past and current services. Pension benefits are a form of deffered compensation
offered by the firm in exchange for services by employees who have chosen, either implicitly
or explicitly, to accept lower current compensation in return for future pension payments.
These pension benefits are earned by employees, and their cost accrues over the years the
services are rendered. Pensions funds may be fully funded, partially funded or unfunded.
Provisions and Contigencies
IAS 37/AASB 137 para. 10 defines a contigent liability as:
a. A possible obligation that arises from past events and whose existence will be confirmed
only by the occurence or non-occurence of one or more uncertain future events not
wholly within the control of the entity, or
b. A present obligation that arises from past events but is not recognised because:
i. It is not probable that an outflow of resources embodying economic benefits will be
required to settle the obligation, or
ii. The amount of the obligation cannot be measured with sufficient reliability.
Owners’ Equity
Owners’ equity represents the net assets (assets minus liabilities) of the entity (P=A – L).
Thus, owners’ equity (or proprietorship) captures the owners’ claims against the entity’s net
assets, which the entity has no current obligation to pay. It represents the owners’ interest or
capital in the firm. Owners’ equity (the residual interest) is a claim or right to the net assets
of the entity. The Framework defines equity in para. 49 (c) as follows:
‘Equity’ is the residual interest in the assets of the entity after deducting all its liabilities.
There are two essential features which can help us to distinguish between liabilities and
owners’ equity. They are:
 The rights of the parties
 The economic substance of the arrangement
Rights of the Parties
A creditor has a claim on the owner(s) and, for a corporation, a claim on the company.
Creditors have the following rights:
 Settlement of their claims by a given date through a transfer of assets (goods or services)
 Priority over owners in the settlement of their claims in the event of liquidation
Another aspects of the rights of creditors and owners relates to the use of the assets or to the
operations of the business. Creditors do not have the right to use the assets of the firm other
than as specified in contracts. Except in an indirect way in some cases, they do not posess
rights in the decision-making process in the operations of the business.

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Economic Substance
Rights Economic Substance
Interest and Settlement Risk and Return
Participation in profits Control
Concept of Capital
Foremost is the requirement of “capital maintenance”, which demands that companies
maintain intact their initial (and any subsequent) capital base. The Framework recognises that
whether or not a firm maintains its capital intact is a function not only of the definition of the
equity as a residual interest in an entity, but also of the concept of the capital. Capital can be
conceptualized as the invested money or invested purchasing power (financial capital) or as
the productive capacity of the entity purchasing power (‘real’) scale.
Classifications within Owners’ Equity
The rationale is to keep separate the amount invested from the amount invested from the
amount that is reinvested. The former is due to financing transactions, whereas the latter is
derived from profit-directed activities. Retained earnings, or unappropriated profits, make up
the earned capital.
In 1950, a special committee of American Accounting Association explained that
appropriations are of three types:
 Those that are designed to explain managerial policy concerning the reinvestment of
profits. This type did not effectively achieve the objective and would be best explained in
narrative from elsewhere.
 Those that are intended to restrict dividends as required by law or contract. In this type,
the committee believed a note to the accounts would be preferable to an appropriation.
 Those that provide for anticipated losses. For this type, the committee felt an appropriation
was unnecessary and often misleading; a note would be more suitable.

CHALLENGES FOR STANDARDS SETTERS

Debt vs Equity Distinction
The classification of financial instruments as liabilities or equity has effects beyond the
balance sheet since the classification determines whether interest, dividends, losses, or gains
relating to that instrument are recognised as income or expenses in calculating net income, or
whether they are treated as a distribution of the calculated profits. Distributions of interest,
dividends, losses, and gains relating to financial instruments or components of financial
instruments that are liabilities are recognised as income or expenses. In contrast, distributions
to holders of an equity instrument are treated as a distribution of the profits once they have
been calculated. In summary, consistent with the theoretical bases of the definitions, IAS
32/AASB 132 requires classification of financial intruments to be based on their economic
substance rather than their legal form. The purpose of distinguishing between owners’ equity
and liabilities is to enhance the usefulness of information for decision making.
Extinguishing Debt
A debt may be settled in ways other than by direct payment or renderring of services to the
creditor. The obligation, for example, may be ‘forgiven’ by the creditor thus releasing the
debtor from making any future sacrifice. IAS 32/AASB 132 outlines offsetting a financial

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asset and liability in para. 42. The situation it deals with is reffered to as the ‘set-off and
extinguishment of debt’ or ‘in-substance defeasance’. This allows a debtor to remove a debt
from the balance sheet and to report a net financial asset or liability only if the entity has a
current legally enforceable right to set off the recognised amounts, and intends either to (a)
settle on a net basis or (b) realise the assets and settle the liability simultaneously.
Employee Shares (Share-Based Payment)
Accountants debate whether share-based payment gives rise to an expense. Another aspects
of the issue is whether the remuneration ‘paid’ to employees by way of company shares or
stock options (option to buy shares) gives rise to liabilities or equity. IFRS 2/AASB 2 Share-
based Payment distinguishes between share-based payments that are cash-settled and those
that are equity-settled. When goods and services are received or acquired in a share-based
payment transcation, the entity records the event when it obtains the goods or as the services
are received. If the goods or services were received in an equity-settled share-based payment
transactions, the credit side of the entry is to owners’ equity. In contrast, if the goods or
services were received in a transaction that will be settled in cash (e.g. an amount of cash
equal to the value of entity’s shares at the time the payment is made), the corresponding
credit entry is to liability. The fair value of transactions in equity-settled plans is determined
on grant date and subsequent changes are ignored. However, the transactions classified as
liabilities under cash-settled plans are adjusted to fair value at each balance date, with gains
and losses included in income. The differential treatment raises the question whether items
which are the same in substance (share-based payment) should be accounted for in different
ways.
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. They are required to gather
evidence that accounts payable, accruals, and other liabilities include all amounts owed by
the entity to other parties. Auditors need to consider the possibility of timing irregularities,
where a liability incurred prior to the end of the financial period is not recorded by the entity
until the commencement of the new accounting period. Cut-off tests are designed to gather
evidence that transactions are recorded in the proper period. In addition, auditors need to test
whether the liabilities are recorded at the proper value. Concealment by managers of the
entity’s obligations, such as contingent liabilities, loan guarantees, or commitments under
various contractual agreements, understates liabilites and creates an impression of greater
solvency for the company.

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REFERENCES:
Godfrey, Jayne, Allan Hodgson, Ann Tarca, Jane Hamilton, and Scott Holmes. Accounting
Theory, 7th Ed. John Wiley & Sons, Inc. 2010. (GOD)