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The Equity Theories and

Financial Reporting: An Analysis
a
Carien van Mourik
a
Open University Business School , Milton Keynes, UK
Published online: 24 Nov 2010.

To cite this article: Carien van Mourik (2010) The Equity Theories and
Financial Reporting: An Analysis, Accounting in Europe, 7:2, 191-211, DOI:
10.1080/17449480.2010.511885

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 Accounting in Europe
Vol. 7, No. 2, 191– 211, December 2010

The Equity Theories and Financial

Reporting: An Analysis
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CARIEN VAN MOURIK

Open University Business School, Milton Keynes, UK

ABSTRACT This paper reviews accounting literature in the English language on

proprietary and entity theory in order to understand their implications for financial
accounting and reporting. Although there is a lack of agreement on the definition and
accounting implications of the various equity theories, the literature indicates clear
differences between pure proprietary and pure entity perspectives of the firm. These
differences particularly relate to the purpose of accounting and financial reporting, the
distinction between debt and equity and its accounting implications for the analysis and
recording of transactions and recordable events, and the definition, determination,
disclosure and distribution of income. The main contribution of this paper is twofold.
First, it explains in operational terms why an entity perspective of the company is
theoretically irreconcilable with the asset –liability approach to the determination of
income. Second, it makes clear that there is always an implicit perspective to financial
reporting. Inconsistency in accounting standards results if the implicit perspective is not
the same as the perceived focus of decision-usefulness.

1. Introduction
In revising and converging their conceptual frameworks the IASB and the FASB
initially made reference to entity theory and the contrasting proprietary theory.
The comment letters (IASB, 2008) in response to the Exposure Draft (IASB/
FASB, 2008a) showed that the once keen debates of 50 years ago and more on
competing equity theories have largely been forgotten. This paper reviews
accounting literature in the English language in order to illuminate the past
debate. It addresses three questions:

Correspondence Address: Carien van Mourik, Open University Business School, Walton Hall, Milton
Keynes MK7 6AA, UK. Email: C.M.VanMourik@open.ac.uk

1744-9480 Print/1744-9499 Online/10/020191–21 # 2010 European Accounting Association

DOI: 10.1080/17449480.2010.511885
Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.
 192 C. van Mourik

. How have researchers defined entity and proprietary theories in the past?
. How are accounting and reporting different under entity theory compared to
proprietary theory?
. How do these differences interact with the IASB/FASB Conceptual Frame-
work project?

The International Accounting Standards Board (IASB) and Financial Accounting

Standards Board’s (FASB) Conceptual Framework project aims to update and
converge the existing FASB and IASB conceptual frameworks. In their exposure
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draft on the objectives of financial reporting the boards included the comment:
‘The boards decided that an entity’s financial reporting should be prepared
from the perspective of the entity (entity perspective) rather than the perspective
of its owners or a particular class of owners (proprietary perspective)’ (IASB/
FASB, 2008a, p. 5). Comments from constituents suggested that the boards did
not understand the differences between these two approaches and in the final
version the reference to these theories is likely to be omitted. If even the standard
setters had no clear grasp of these theories, it seemed useful to prepare a detailed
analysis that might help to illuminate such debates.
The literature indicates that proprietary views of the company see the purpose
of income determination as measuring the increase in wealth of the owners using
the asset – liability approach leading to net income to common shareholders as the
bottom line. Retained earnings are typically perceived as belonging to the share-
holders. A proprietary notion of decision-usefulness gives priority to the infor-
mation needs of investors in stocks and shares and nominally includes the
needs of debt security holders.
There appear to be conflicting interpretations of entity theory leading to incon-
sistencies in accounting treatments advocated by various theorists. Pure entity
views of the firm however, regard the purpose of income determination as provid-
ing a measure of performance using the revenue – expense approach which
enables the company’s survival and the alignment of all its stakeholders’ inter-
ests. The liabilities side of the balance sheet does not distinguish debt from
equity but shows liabilities in order of decreasing seniority. The income state-
ment shows expenditures incurred to satisfy obligations to all stakeholders
either as expenses in the determination of enterprise income or as distributions
of enterprise income. Retained earnings are perceived as belonging to the
company. A pure entity notion of decision-usefulness gives priority to the infor-
mation needs related to the entity’s survival and the coordination of all the stake-
holders’ interests, and ideally also to contribution and accountability to society.
This paper contributes to a clearer definition and understanding of entity and
proprietary views of companies. It shows that the entity view of the firm is incon-
sistent with the asset– liability approach to income determination. This may be of
importance to the IASB/FASB Conceptual Framework project for the purpose
of consistency in financial accounting standards. It also argues that the
 The Equity Theories and Financial Reporting 193

asset – liability approach is politically more easily acceptable to countries with

free market economies where the shareholder model of corporate governance
is dominant. The revenue – expense approach on the other hand is politically
better suited to countries that have more mixed economies where the stakeholder
model of corporate governance is more appropriate.

Structure of this Paper

Entity theory and proprietary theory are two perspectives of companies subsumed
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under the heading equity theories. Section 2 reviews extant literature on the rel-
evant equity theories in the English language. Section 3 summarises the potential
impact on financial reporting of applying these theories. Section 4 discusses
some implications of the entity concept for the Conceptual Framework project.
Section 5 presents some general conclusions.

2. Equity Theories: A Literature Review

Equity theories were a popular topic of journal articles from the 1930s to the
1960s. According to Mattessisch (2008, pp. 29 – 30), entity theory only fully
replaced proprietary theory in the second half of the 20th century. Seidman
(1956, p. 64) on the other hand suggests ‘a full swing from an agency to an
entity back to an agency concept’. Either way, in the 1970s equity theories
started collecting dust in accounting theory textbooks or disappeared altogether
from most accounting academics and practitioners’ frame of reference.

Functions of Equity Theories

Equity theories provide different views in answer to the question whose point of
view should be taken in the accounting process of companies (Kam, 1990,
p. 302). The point of view taken in the accounting and reporting process deter-
mines the perspective from which accounting transactions are analysed and the
way in which they are recorded and accounted for. According to Hendriksen
and Van Breda (1992, p. 766) equity theories interpret the economic position
of the enterprise in a different way leading to a different emphasis in disclosing
the interests of stakeholders as well as different concepts of income. More specifi-
cally, Schroeder et al. (2001, p. 305) claim that ‘Theories of equity postulate how
the balance sheet elements are related and have implications for the definitions of
both liabilities and equity.’ Zeff (1978, p. 1) uses the term ‘orientation postulate’
with regard to the point of view taken in the accounting process because whether
explicit or implicit, ‘a perspective must find expression somewhere in the theor-
etical construct’.
Lorig (1964) believed that the direct impact of equity theories is limited to
items which appear on the credit side of the balance sheet, including debt
capital, equity capital and possibly ‘the equity of the accounting entity in
 194 C. van Mourik

itself’ (p. 564). Most discussions in the literature do indeed focus on the differ-
ences of the proprietary and entity perspectives on accounting for interest,
stock and cash dividends, and income taxes, for example: Husband (1938,
1954), Lorig (1964) and Bird et al. (1974). Other examples include discussions
of stockholder income, dividends and taxation (Seidman, 1956), capital and
retained earnings (Li, 1960a), donated fixed assets (Borth, 1948), treasury
stock (Ray, 1962), dividends (Horngren, 1957; Li, 1960b), income taxes (Li,
1961) and government subsidies. Sprouse (1957) compares proprietary, entity,
enterprise and legal concepts of the corporation with regard to interest charges,
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income taxes and dividends.

Looking at the English language literature one gets the distinct impression that
most of the writers on this issue believe that there is only one correct answer to
the question of whose perspective should be taken in the accounting process.
Those who believe that accounting should be conducted from the shareholders’
point of view would support the proprietary theory or a variation thereof (Hat-
field, 1909; Sprague, 1913, pp. 46– 49; Husband, 1938, 1954; Staubus, 1952,
1959). Those who believe that the accounting process should be conducted
from the business entity’s view would adhere to a form of entity theory
(Gilman, 1939; Paton and Littleton, 1940; Chow, 1942; Suojanen, 1954, 1958;
Seidman, 1956; Raby, 1959; Li, 1960a, 1960b, 1961, 1963). Then there are
those who have a more functional approach, and believe that accounting does
not necessarily need to take anyone’s perspective in particular. Proponents of
the functional approaches referred to by Meyer (1973) are Canning (1929),
Vatter (1947, 1962), American Accounting Association (AAA, 1957) and Gold-
berg (1965).

What Equity Theories are There?

Hendriksen and Van Breda (1992, chap. 22) distinguish between proprietary,
entity, residual, enterprise and fund theories of equity. Chatfield (1977,
chap. 16) and Schroeder et al. (2001, chap. 14) identify all of the above plus
the commander view of the firm. Meyer (1973) describes eight conceptions of
the accounting entity falling into three categories. He categorises the concepts
as follows:

The proprietary approaches: the traditional proprietary view, the residual

equity view, the equity view
The pure entity approaches: the self-equity view, the social view
The functional approaches: the AAA enterprise view, the fund view, the
commander view.

At the one extreme, profits belong to the proprietors and at the other extreme
profits belong to the business entity. The functional approaches ‘refrain from
setting up priorities among interests’ (Meyer, 1973, p. 125). This paper is not
 The Equity Theories and Financial Reporting 195

concerned with the functional approaches because they have not found much
support in the practice of business accounting.
This literature review uses the same names for the various proprietary and
entity approaches as in Meyer (1973) but classifies the equity view separately.
It will first discuss the traditional proprietary and residual equity views as the
two proprietary approaches. Then, it discusses the equity view, which Meyer
(1973) considers a proprietary approach but which is similar to entity theory as
described by, for example, Hendriksen and Van Breda (1992) and the entity
perspective as proposed by the IASB/FASB Conceptual Framework project.
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Depending on the hardness of the distinction between debt and equity as

evidenced by the treatment of transactions between a company and its share-
holders and the corresponding choice of approach to income determination, the
equity view becomes either a proprietary approach or a pure entity approach.
Finally, this literature review discusses the self-equity and enterprise
(or social) views, which like Meyer (1973) it regards as pure entity approaches.

(a) Proprietary theory

Two forms of proprietary theory are the traditional proprietary view and the
residual equity view. Proprietary theory sees the main functions of financial
accounting as the determination of the increase in the shareholders or residual
equity holders’ wealth and providing information to equity holders more than
to any other possible stakeholders.

The traditional proprietary view

The traditional proprietary perspective predates the entity perspective in financial
reporting. The former grew out of the personification of accounts (Chatfield,
1977, pp. 219 – 223). ‘Those who believe that the accounting entity should be per-
sonified are known as the proprietary theorists, and those who believe that the
entity should not be personified are known as the entity theorists’ (Kell, 1953,
p. 42). Kell’s logic is as follows. Because under the proprietary view transactions
are analysed as to their effect on the proprietors, one could say that in this case the
accounting is personified. Under the entity view, however, transactions are
analysed as to their effect on the business entity, and accounting is therefore
not personified (Kell, 1953, p. 41).
Proprietary theory is an agency concept. In a traditional agency setting finan-
cial reports are prepared by the managers for the purpose of providing infor-
mation to the proprietors on the basis of which, the managers were held
accountable for their stewardship. Proprietors would then release the managers
of their responsibility for the results for the past period.
According to proprietary theory accounts are prepared from the viewpoint of
the proprietor(s) and are ultimately meant to measure and analyse their net
worth expressed by the accounting equation:
 196 C. van Mourik

  
assets − liabilities = proprietorship or net worth (1)

In the traditional proprietary view, the assets are the proprietors’ assets, and the
liabilities are the proprietors’ liabilities. According to Newlove and Garner
(1951, p. 21) under proprietary theory ‘[l]iabilities are negative assets – negative
properties, which must be sharply defined and separated in the accounting
process’. Revenues are increases in proprietorship and expenses are decreases.
Net profits, ‘the excess of revenues over expenses, accrues directly to the
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owners; it represents an increase in the wealth of the proprietors’ (Hendriksen

and Van Breda, 1992, p. 770). In other words, all transactions are analysed,
recorded and accounted for as to their immediate effect on proprietorship.
Under traditional proprietary theory the distinction between debt and equity is
absolute. This relates to the fact that proprietorship is determined as net assets.
Equity is not considered a liability of the entity to the proprietor except for book-
keeping purposes. As a consequence, under the proprietary view of the company
there are transactions or events that are considered non-reciprocal transfers
between a business and its shareholders (the proprietors). In addition, the proprie-
tary view also allows for the existence of non-reciprocal transfers between a
business and outsiders. Non-reciprocal transfers are transactions where the
business receives but does not pay or transactions where the business pays but
does not receive. APB Statement No. 4 was based on such a classification.
Examples of non-reciprocal transfers between the enterprise and its owners
include: ‘investments of resources by owners, distributions of cash or property
dividends, acquisition of treasury stock, and conversion of convertible debt’
(APB Statement No. 4, 1970, para. 62; Bird et al., 1974, p. 237) and stock-
based compensation (Newberry, 2001). Examples of non-reciprocal transfers
between the enterprise and entities other than owners include: ‘gifts, dividends
received, loss of a negligence lawsuit, imposition of fines, and theft’ (APB State-
ment No. 4, 1970, para. 62; Bird et al., 1974, p. 237).
Proprietary theory does not allow non-reciprocal transfers to be accounted for
as exchanges from the viewpoint of the accounting entity. The reason is that
under the proprietary view ‘an enterprise cannot enter into an exchange with
its owners because it cannot obligate itself to the owners. Concomitantly, when
the enterprise distributes resources to its owners it cannot receive a release
from any obligation to them’ (Bird et al., 1974, pp. 236– 237). In other words,
under the proprietary approach all non-reciprocal transfers are accounted for
with a view to their effect on owners’ equity. It does not allow for liabilities
that are not either debt or equity because it does not allow the entity to have
equity in itself as everything that is not debt must automatically be owners’
equity.
This hardness of the distinction between debt and equity leads to a definition
and disclosure of net income as ‘net income to shareholders’. ‘From the point
of view of the proprietor any payment to an outsider necessary to the conduct
 The Equity Theories and Financial Reporting 197

of the business is a cost or an expense’ (Chow, 1942, p. 157). Under a narrow

interpretation of the proprietary concept even cash dividends to preferred share-
holders represent an expense to the company (Sprouse, 1957, p. 376). From both
the perspectives of the stockholders and that of the company under the proprie-
tary view, cash dividends on common stock are a distribution of income to the
co-owners of the corporation (Sprouse, 1957, p. 376; Lorig, 1964, p. 570).
Because retained earnings belong to the shareholders, stock dividends on
common stock declared out of retained earnings or paid in surplus represent
merely a rearranging of shareholders’ equity.
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As debts are a liability of the proprietors, interest payments are considered an

expense. Corporate income tax however represents a taxation of the stockholders’
income. Taxation of personal income including dividends therefore results in
double taxation. All other taxes are operating expenses.
The purpose of income determination under the proprietary view is to deter-
mine the increase in the proprietor’s wealth. Income from the proprietor’s
perspective or in the case of public limited companies the shareholder’s perspec-
tive is a net worth concept that expresses the increase in wealth using the asset –
liability approach. Some believe that assets and liabilities should therefore be
measured at current cost or fair value rather than historical cost. For example,
Hatfield (1909, p. 83) espoused valuation of inventory on a going concern
basis (i.e. current cost), and valuation of fixed assets on a historical cost basis
as long as depreciation is taken into account. Sprouse and Moonitz (1962) advo-
cated the asset – liability approach and reduced importance of the realisation prin-
ciple in the valuation of assets. See also Bird et al. (1974, p. 242). Either way, it is
extremely important to define, recognise and measure assets and liabilities pre-
cisely and reliably.
Furthermore, if income is the increase in the net assets of the owner during a
given period, ‘then all aspects that affect a change in wealth of the owner in that
given period should be included in income’ (Kam, 1990, pp. 303 – 304). In other
words, the all-inclusive concept of income (clean surplus relation) applies to the
proprietary view which means that holding gains and losses on assets and liabil-
ities as well as non-recurrent profits or losses should be included in the determi-
nation of income for the period. The proprietary theory forms the basis for the
comprehensive income concept (Hendriksen and Van Breda, 1992, p. 770)
which is advocated by the FASB and the IASB.

The residual equity view

Residual equity theory is a variation of proprietary theory which explicitly takes
into account the change in the nature of the business entity from a legal view
when a business becomes insolvent. It is also the view that is closest to
the legal approach of the company, insolvency and tax laws. Staubus, the
main proponent of the residual equity theory explains residual equity as
follows:
 198 C. van Mourik

In what are thought of as normal business situations, the claimants of the

residue of assets (the holders of residual equity) are owners. [. . .] In ‘abnor-
mal’ business situations, the owners’ equity, as reported in the balance
sheet, may be reduced to nothing by losses; at that point, the general credi-
tors become residual equity holders.
(Staubus, 1959, p. 8)

This theory is also referred to as the investor theory because of the idea that
‘accounting functions and financial statements should take the point of view of
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investors’ (Kam, 1990, p. 313).

The purpose of financial reporting according to Staubus (1959, p. 6) is to
‘provide any accounting information which will be of assistance in making a
choice between investing and not investing [. . .] it must be information related
to the times and amounts of the investor’s future cash receipts from the invest-
ment relationship’. Accounting and financial reporting should take the point of
view of investors because the function of financial reporting is to provide infor-
mation to suppliers of capital. The accounting equation according to the residual
equity theory is (Staubus, 1959, p. 13):

Assets − Specific Equities (= Liabilities + Preferred Stock)

= Residual Equity. (2)

In normal business situations specific equities include the claims of creditors,

long-term lenders and preferred shareholders. However, in abnormal business
circumstances ‘the equity of common stockholders may disappear and the
preferred stockholders or bond holders may become the residual equity
holders’ (Hendriksen and Van Breda, 1992, p. 773). In other words, transactions
are analysed, recorded and accounted for as to their effect on the business’s
residual equity holders, usually the common shareholders.
When it comes to the non-reciprocity of external transfers, Staubus (1961,
p. 61) distinguishes 18 categories of economic events, two of which are trans-
actions between the economic unit and its residual equity holders leading to
either increments (investment by proprietor or partner, issuance of common
stock) or decrements (withdrawal by proprietor, declaration of dividend on
common stock, purchase of treasure stock by a company) in a net asset item
and the residual equity. The sharp distinction between debt and equity of a
going concern becomes a sharp distinction between specific equities and
residual equity in the case of a business in liquidation. Staubus (1961, p. 62)
also distinguishes one-sided receipts and costs from two-sided receipts and
costs, the former of which always cause an increase or decrease in residual
equity.
Because the residual equity holders of a business in liquidation are not the
same as the residual equity holders of a going concern the determination of
 The Equity Theories and Financial Reporting 199

income to residual equity holders must emphasise its dependent position. Under
the going concern assumption the residual equity separately disclosed in the
balance sheet is considered a buffer to all investors, except the residual equity
holders to whom it represents a measure of their claim. Investors’ interest in
the income statement focuses on the change in the residual equity (Staubus,
1959, p. 10).
The buffer function of the residual equity and the residual nature of common
stockholders’ income shift the focus of the function of accounting information to
being useful to all investors in assessing the timing and amount of their cash
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receipts. Staubus (1961, p. 51) ranks asset measurement techniques in order of

their relevance to residual equity holders as follows: (1) counting money, (2) dis-
counted future money movement, (3) net realisable value, (4) replacement cost,
(5) adjusted historical cost and (6) original money cost.
Balance sheets according to Staubus (1959, pp. 6 – 8) must give a clear picture
of the residual and other equities. The income statement’s main functions are to
account for the difference in residual equity and to enable investors to assess the
accounting entity’s ability to pay its obligations as well as its willingness to pay
cash dividends. He also stressed the importance of cash flow information to
investors. Staubus (1961, pp. 110– 111) proposes a statement of assets and
equities stressing the difference between monetary and real assets and specific
equities (¼ debt) and a revenue and expense statement (Staubus, 1961, p. 130)
where the bottom line is recurring income to common shareholders.

The boundaries of the accounting and reporting entity under the proprietary
views
With regard to consolidation, Baker et al. (2005, p. 113) take the view that ‘the
proprietary concept results in a pro rata consolidation. The parent company con-
solidates only its proportionate share of the subsidiary’s assets and liabilities.’
Another view is expressed by Kam (1990, p. 304):

In consolidating financial statements, the parent company method is based

on the proprietary theory. The parent company is seen as ‘owning’ the
subsidiary. Minority interests, from the point of view of the ‘owner’ of
the subsidiary, represent the claims of a group of outsiders.

Minority interests should therefore be considered a liability on the balance sheet.

Schroeder et al. (2001, p. 483) do not mention the proprietary theory as a basis for
consolidation but do mention that the parent company theory evolved from the
proprietary theory of equity. However, according to Baxter and Spinney (1975)
and Baker et al. (2005) the parent company theory is somewhere between the
proprietary and entity theories. For non-consolidated long-term investments the
equity method is the appropriate approach under the proprietary theory (Kam,
1990, p. 304; Hendriksen and Van Breda, 1992, p. 771).
 200 C. van Mourik

(b) The equity view (in between proprietary and entity)

The equity view corresponds largely to Paton and Littleton’s application of the
entity theory (1940). In this view financial accounting and reporting serve the
purpose of accountability to the suppliers of both debt and equity capital, and
must report information that is useful for their investment and resource allocation
decisions. It is an entity perspective because it sees the entity as independent from
the owners. It analyses most transactions with respect to their effect on the entity
and determines income by the revenue – expense approach. However, it also
resembles a proprietary perspective because it sees management as the share-
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holders’ agents, stresses the residual nature of shareholders’ interests, and thus
it focuses primarily on the information needs of investors, particularly investors
in equity capital and considers retained earnings as belonging to common share-
holders rather than to the entity. This appears to be the IASB/FASB’s interpret-
ation of the entity perspective.
Although the equity view considers the business to exist as an entity separate
from its founders or owners, the balance sheet equation under this view as found
in Hendriksen and Van Breda (1992, p. 771) describing the entity view is as
follows:

  
assets = debt capital + stockholders′ equity capital. (3)

To the extent that there is a sharp distinction between debt and equity in the
accounting for transactions with shareholders, the equity view becomes a proprie-
tary view instead of an entity view. Such a sharp distinction is necessary to main-
tain that there can be non-reciprocal external transfers, and that the entity cannot
have equity in itself. It is also necessary if income is to be determined using the
asset – liability approach.
In his early days, Paton maintained that even income tax payments are distri-
butions in favour of the underlying equity of the state and cannot reasonably be
viewed as an expense (Paton, 1922, pp. 180– 181, in Meyer, 1973, p. 118). In
other words, like the pure entity theorists, he considered the state to have an
underlying equity in the company. He later changed his opinion on the reason-
ableness of the government’s underlying equity and forcefully condemned
double taxation, presumably in response to what he calls ‘[h]arassment of our
businesses through punitive tax measures [. . . and] an unfriendly attitude
toward private enterprise’ (Paton, 1965, p. viii).
Inconsistencies arise especially in accounting for undistributed profits because
not all interpretations of the entity theory regard undistributed profits as the
entity’s equity in itself. Examples of those include: Gilman (1939, p. 48),
Paton and Littleton (1940, p. 105), Newlove and Garner (1951, p. 21), and
Paton (1965, chap. 2). Such inconsistencies in accounting treatments have been
identified by Husband (1938, pp. 243– 244). Bird et al. (1974) give examples
of inconsistencies in accounting standards concerning external transfers at the
 The Equity Theories and Financial Reporting 201

time. More recent examples are discussed by Mozes (1998) and Newberry (2001,
2003). Inconsistencies in accounting for external transfers arise from the fact that
it has been impossible to settle the debate on which mutually exclusive concept of
income must be applied in accounting standards and practice.
One concept sees income as a measure of performance, and the other views
income as an enhancement of investors’ wealth (agency perspective). See also
Newberry (2003, pp. 327– 329). The former is expressed as the revenue –
expense approach and the latter takes the form of the asset – liability approach
to income determination. In addition, the former regards all transactions as reci-
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procal transfers whereas the latter regards some transactions such as dividend
payments, receipt of subsidies and donated assets, etc. as non-reciprocal transfers.
In the entity perspective/revenue – expense approach such transactions are
recorded as to their effect on the entity’s and the entity’s equity in itself. Follow-
ing the proprietary/asset – liability approach such transactions are analysed,
recorded and reported as to their direct effect on proprietorship. See also Bird
et al. (1974) and Newberry (2001). Regarding some transactions as non-recipro-
cal is logical within a proprietary view where debt and equity are strictly separate,
and where all transactions are analysed as to their effect on proprietorship. On the
other hand, in an entity view of the company non-reciprocity does not exist. Not
choosing between the two views of the firm and consequently not choosing
between the two approaches to income determination leads to inconsistencies
in accounting standards.
Lack of clarity and definition of the entity approach originates from two
causes. The first is the fact that in the English language literature entity theory
and proprietary theory thus far have not been correctly associated with the
revenue – expense and asset – liability approaches to income determination,
respectively. The second is the fact that some entity theorists regard retained
earnings as belonging to shareholders instead of to the entity.

(c) Entity theory

Entity theory developed out of the concept of limited liability of a company’s
shareholders. ‘Littleton considers medieval agency accounting a forerunner of
the entity theory, which in this sense predated the corporation itself’ (Chatfield,
1977, p. 224). 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).
In other words, the company’s assets belong to the entity instead of to the
shareholders. As a consequence, transactions are analysed as to their effect on
the business entity. In addition, both debt and equity capital are liabilities of
the company. Net profits under the entity theory belong to the business.

Revenue is the product of the enterprise, and the expenses are the goods
and services consumed in obtaining the revenue. Therefore, expenses are
 202 C. van Mourik

deductions from revenue, and the difference represents the corporate

income to be distributed to stockholders in the form of dividends or
reinvested in the business.
(Hendriksen and Van Breda, 1992, p. 772)

According to Kam (1990, p. 306) two versions of entity theory exist. The first
is the traditional version which sees the enterprise as operating for the benefit of
its debt and equity holders. This is the version that corresponds to what Meyer
(1973) calls the ‘equity view’ and considers a proprietary approach which has
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been discussed under (b). The second version is similar to Meyer’s ‘self-equity
view’ according to which the corporation acts in its own best interest rather
than in that of its shareholders (Meyer, 1973, p. 119; Kam, 1990, p. 306).

The self-equity view

The second and newer interpretation of the entity theory regards ‘the entity as in
business for itself and is interested in its own survival’ (Kam, 1990, p. 306). This
is the entity concept as defined by Li (1960a, 1960b, 1961, 1963, 1964). In
Meyer’s classification (1973) this would be the ‘self-equity view’ which is a
pure entity approach. It is also the name used here.
The purpose of financial accounting in this case is to meet legal requirements
and to maintain good relationships with suppliers of debt and equity capital as a
means to ensure its survival and enable the business entity to raise additional
capital if necessary (Kam, 1990, p. 306). According to Li the large corporation
strives to make profits in order to survive and maintain economic and financial
competence (1960a, pp. 258– 259). It does not primarily strive to maximise
profits (or shareholder value) for the purpose of enriching the shareholders or max-
imising the shareholders’ utility. Attracting capital providers is necessary for the
company’s survival, but as a company goal it is secondary to its survival (Li, 1964).
Raby’s position is that from a transaction viewpoint no one really owns a
company or economic entity. Therefore, the responsibility of management as
the entity’s governing group must be first to the entity itself rather than to the
shareholders or other stakeholders (Raby, 1959, p. 454).
According to the pure entity theory accounts are prepared from the viewpoint
of the entity. The accounting equation according to the entity theory following
Paton (1922) is
 
assets = liabilities (4)

or
 
assets = equities. (5)
 The Equity Theories and Financial Reporting 203

As in the equity view, the liabilities of the enterprise include both debt and
equity. But the distinction between the two is not as pronounced as under the
proprietary views. Assets are the assets of the company in the same way that
the liabilities are the liabilities of the company.
The self-equity view is a pure form of the entity theory because it sees debt and
equity as liabilities of the business entity. The contractual obligations are differ-
ent in nature, but for a going concern in the self-equity view these differences
only matter in terms of finding the optimal mix of sources of funding to suit its
strategic, operational and financing objectives. In this view there are no non-
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reciprocal external transfers. As a consequence, under the entity theory it is

perfectly acceptable and logical for the entity to have equity in itself. In this
view retained earnings belong to the entity, not to the shareholders.
Corporate income taxes are not considered a form of double taxation.

Only in the case of the close or privately held corporation (where the cor-
poration is not really a corporation at all, but merely a convenient device
utilised by a few) does the claim of double taxation possess an important
degree of validity.
(Seidman, 1956, p. 69)

Under the self-entity view cash dividends to preferred shareholders and ordin-
ary shareholders as well as interest payments to bondholders and corporation
income tax payments represent either a distribution of income (Assets ¼ Equi-
ties) or can be viewed as an expense to the company in order to determine the
entity’s own net income in the form of retained earnings (Assets ¼ Liabilities).
Sprouse (1957, pp. 372 – 373) noted that the Asset ¼ Equities view leads to the
question what to call interest payments made to bondholders in case of corporate
losses. Similarly, when there are no profits there will be no income tax payments
but there will be interest payments and there may still be dividend payments. Li
(1961, p. 268) holds that income taxes are the cost of being a separate entity.
Stock dividends have the effect of restricting further asset dividend paying pos-
sibilities by increasing legal capital and decreasing general surplus (Horngren,
1957, p. 381). From the perspective of the company, however, stock dividends
represent a distribution of income if they are paid out of retained earnings
(which belong to the entity), but not if they are paid out of paid-in surplus
because that represents a liability to the stockholders (Lorig, 1964, p. 571). Li
(1960b, p. 679) views cash dividends as an insurance cost and stock dividends
as a form of recapitalisation designed to attract additional capital by decreasing
the stock price per share and by increasing legal capital.
Income under the self-equity view is a measure of the company’s performance
rather than an enhancement of investor wealth. This is consistent with the
revenue – expense method and accrual accounting espoused by Paton and Little-
ton (1940) to determine a business entity’s income.
 204 C. van Mourik

Many early writers associate the revenue – expense approach and accrual
accounting with historical costs. Lorig (1964, p. 572) for example considers
cost the best basis for asset valuation under the entity theory. ‘[T]he firm is not
concerned with current values because the emphasis is on the accountability of
cost to the owners and other equity holders’ (Hendriksen and Van Breda, 1992,
pp. 772 –773). Bird et al. (1974, p. 242) state that price level adjustments are
acceptable under the entity theory. This excludes current exchange values such
as entry and exit values. The reason is that the exchanges did not take place at
current values.
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The social view/enterprise theory

The enterprise theory sees the large listed corporation as an institution with
social responsibilities. It is therefore a broader concept than the self-equity
form of entity theory. Companies’ actions affect many different stakeholders
such as stockholders, creditors, customers, employees, the government as a
taxing and regulatory authority and the public at large (Suojanen, 1954; Kam,
1990; Hendriksen and Van Breda, 1992). Suojanen traces this institutionalisation
of the large enterprise to the separation of management and ownership leading to
increasingly large proportions of income being retained within the company to
reduce the corporation’s dependence on external financing. Large corporations
may decide to pay only ‘conventionally adequate dividends’ because this ties
in with their survival and growth objectives. In his interpretation an additional
source of funds is provided by depletion and depreciation allowances (Suojanen,
1958, pp. 56– 57).
Suojanen proposes that large companies prepare a value added concept of
income measurement and a value added statement in addition to the normal
financial statements such as the balance sheet and income statement. ‘If the
enterprise is considered to be an institution, its operations should be assessed
in terms of its contribution to the flow of output of the community’ (Suojanen,
1954, p. 395).
Financial reporting according to the enterprise theory is to be prepared from
the perspective of the enterprise as a social institution. The accounting equation
expressing the enterprise theory according to Meyer (1973, p. 120) is

assets = investors’input contributions. (6)

‘From the point of view of all participants, all payments (disbursements of assets)
to any participant are distributions of revenue’ (Meyer, 1973, p. 120). ‘Although
stockholders have legal rights as owners, from the point of view of the enterprise
their rights are subsidiary to the organization and its survival’ (Kam, 1990,
p. 315). In this respect enterprise theory is similar to the self-equity view. As
income generated by the enterprise is analysed to measure the contribution of
the enterprise to society using the concepts developed in national income
 The Equity Theories and Financial Reporting 205

analysis, ultimately the balance sheet is secondary to output, income and value
added considerations.

[T]he enterprise theory considers that output is the relevant measure of

income in the value added statement; profitability or net income, is
measured in the income statement. It follows that the amount appearing
in the retained earnings account is imputed to the enterprise.
(Suojanen, 1954, p. 396)
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For this purpose inventories and goods produced would be valued at their selling
price. Apparently, net profit in the income statement and profit in the value added
statement do not have to correspond to each other at any given time although
‘both methods of income determination will result in reporting the same
income over time. [. . .] [N]o basic antagonism exists between the value added
and the customary procedures of enterprise reporting’ (Suojanen, 1954, p. 397).
Value added consists of gross profits and the value added statement shows how
the value added has been distributed to employees, providers of debt and equity
capital, government, and how much profit has been retained in the enterprise for
the purpose of its expansion. The income statement allows the alignment of the
interests of all stakeholders. In the equity and self-equity views that means all
investors (stockholders and holders of long-term debt), and in the social view
that means all stakeholders including the government and all of society. In the
latter case the income statement and statement of retained earnings could take
a form similar to the one presented by Clark (1993, p. 21) or could be sup-
plemented by a value added statement. The value added statement holds manage-
ment accountable for its responsibilities to all the stakeholders in the enterprise as
a social institution and not to its stockholders or investors alone.
The social view considers profits

as the extent to which an entity has increased its assets through operations,
as the economic contribution which an entity has made to the economy in
which it operates, and as a measure of efficiency with which a business
entity has carried out its responsibilities for the economic development
of society.
(Bedford, 1965, pp. 179 – 180 quoted in Meyer, 1973, p. 120)

The boundaries of the accounting entity under the entity views

Lorig was of the opinion that according to the entity theory consolidated financial
statements present an inappropriate view because the relation between a parent
and a subsidiary company is of a debtor – creditor rather than ownership nature
(1964, pp. 570 –571). Not consolidating subsidiary companies that are under
the effective control of a parent company gives managers enormous scope for
moral hazard. Majority shareholders, current and prospective investors and
 206 C. van Mourik

long-term creditors require information about the activities and resources of the
overall economic entity. In addition, top management is generally evaluated on
the basis of the overall performance reflected in the consolidated financial state-
ments (Baker et al., 2005, p. 98 –99).
Therefore, under the entity approach the emphasis is on the consolidated econ-
omic entity itself. Controlling and non-controlling shareholders are viewed as
two separate groups with an equity stake in the consolidated entity neither of
which is emphasised over the other. The full amounts of assets and liabilities
are combined in the consolidated balance sheet. Consolidated net income is
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made up of a combined figure that is allocated between the controlling and

non-controlling interest groups (Baker et al., 2005, pp. 115– 116). ‘To show min-
ority interest as a liability is inconsistent with the entity approach’ (Moonitz,
1942, p. 238).

3. Equity Theories: Implications for Financial Reporting

It can be seen from the analysis of the literature above that different authors have
been able to generate significantly different approaches to financial reporting
based on variants of the two main theories. Table 1 summarises the five
approaches. In the first instance the choice of perspective orients financial report-
ing to a narrower or broader group of users. Proprietary theory primarily con-
siders the information needs of shareholders and perhaps investors in debt

Table 1. The purpose of financial reporting, balance sheet equations and income
determination
Balance Income
Company Purpose of financial accounting sheet determination
view and reporting equation approach
Proprietary/ Accountability to owners, A2D¼E Asset– liability
agency stewardship, release from
responsibility
Residual Provide useful information to A 2 Sp.Eq. Asset– liability
equity investors related to future cash ¼ RE
receipts
Equity Decision-usefulness to investors A¼D+E Asset– liability or
revenue –expense
Self-equity Meet legal requirements and A ¼ L or Revenue– expense
maintain good relations with A¼E
investors
Enterprise/ Meet legal requirements and A ¼ Input Revenue– expense
social maintain good relations with contrib.
investors + assessment of
contribution to society ¼ align
all the stakeholders’ interests
 The Equity Theories and Financial Reporting 207

securities, while entity theory includes the information needs of all providers of
capital or even all direct and indirect stakeholders.
Furthermore, the perspective chosen affects the determination of income and
the analysis of transactions. A proprietary view supports a view of income as
being the net change in assets and liabilities over the period. Taken to its
logical conclusion this could mean that all assets and liabilities should be
measured at current value, and the profit for the year would include value
changes as well as transactions and non-recurrent items. The entity view
embraces accountability to a wider range of stakeholders and sees financial
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reporting as instrumental in aligning all their different interests. Table 2

roughly summarises some of the accounting implications of the proprietary and
entity approaches featured in the literature.
Two financial reporting issues that are central to the entity approach are that
the distinction between debt and equity is not fundamental to the display of finan-
cing on the balance sheet, and that payments to stakeholders can be regarded as
distributions of income. When the debt/equity divide is not critical, there is a
stronger case for an approach, such as that of a discussion paper from the Euro-
pean Financial Reporting Advisory Group (EFRAG) which suggests an ordering
of financing in terms of residual risk in bankruptcy.

4. The Conceptual Framework and Equity Theories

Following the comments on the Exposure Draft, the IASB and FASB are likely to
abandon any reference to entity and proprietary theories in the objectives of
financial reporting. In my opinion this is unfortunate because a conceptual frame-
work is an appropriate place for clarifying all the concepts and their accounting,
reporting and welfare implications before motivating a choice. The conceptual
framework project has fully embraced a decision-usefulness perspective where
income as determined by the asset – liability approach is meant to help estimate
the timing, risk and amount of cash flows to investors. Therefore, so far in prac-
tice, the conceptual framework project has been more proprietary than entity in
orientation. The real evidence will be in the accounting standards that follow
from the Conceptual Framework.

5. Conclusions
This literature review shows that the proprietary and entity theories originated at
different times in history and have not been developed continuously since. The
equity theory literature is notably undeveloped with respect to the determination
of the boundaries of the reporting entity. Another area that needs further clarifi-
cation is the distinction between capital and income as legally enforced by divi-
dend restrictions in different countries and jurisdictions. When applied logically
and transparently, the different views of the firm provide a basis for accounting
standards and practice in terms of the purpose of financial accounting and
 208 C. van Mourik

Table 2. Some accounting implications of proprietary and entity views

Transactions/ Proprietary/agency/residual
events equity Self-equity/enterprise/social
Analysed with The proprietors The entity
respect to:
Sales Sales revenues increase Sales revenues increase income
proprietorship as a measure of operating
performance
Purchases Purchase expenses decrease Purchase expenses decrease
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proprietorship income as a measure of

Investments of Record asset at fair value and
resources by corresponding increase in
owners paid-in capital or donated
surplus
Gifts and Record asset at fair value and
donations by corresponding increase in
third parties income or retained earnings
Appreciation in Record increase in value and
value of assets corresponding revaluation
reserve or gain included in
income
Salary payments Disclosed as an expense
in income statement
Corporate income Disclosed as an expense
tax payments in income statement
Interest payments Disclosed as an expense
on debt capital in income statement
Cash dividends Distribution of income, reduces
retained earnings
Stock dividends Rearrangement of shareholders’
stock splits equity
Retained earnings Belong to the shareholders
Additional Cash flow statement
statement
operating performance
Record asset at fair value and
corresponding increase in
paid-in capital or donated
surplus
Record asset at zero value or
disclose in notes to the B/S
Supplementary disclosure in the
notes to the B/S
Disclosed as a distribution
of income in the income
statement
Disclosed as a distribution
of income in the income
statement
Disclosed as a distribution
of income in the income
statement
Distribution of income, reduces
retained earnings
Distribution of income if paid
out of retained earnings
Belong to the entity
Value added statement

reporting as well as the determination and distribution of income. However, they

can only do so within an appropriate economic, social and political context.
For accounting standard setters, be they private or public, the choice for a view
of the company must be guided by the objective of accounting regulation with
regard to social objectives and the political influence of different constituencies.
The above discussion of equity theories has hopefully demonstrated that there is
always either a proprietary (income as measure of increased shareholder and
investor wealth) or an entity perspective (income as a measure of the entity’s per-
formance and contribution) to the purpose of accounting and reporting. Choosing
 The Equity Theories and Financial Reporting 209

a perspective of the company and consequently a proprietary or entity notion of

decision-usefulness is essentially a political instead of technical decision as it has
clear consequences for the perceived importance and immediacy of stakeholders’
financial accounting information and income distribution needs. ‘Accounting is
not simply a neutral technology for economic decision-making; it sanctions
particular distributions of wealth and legitimises particular social relationships’
(Maltby, 2000, p. 68).
The paper points out the inconsistency between the entity concept and the
asset – liability approach to income determination. The IASB/FASB Conceptual
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Framework project is carried out in an international environment where market,

financial and political institutional characteristics differ between countries.
Currently, the IASB/FASB Conceptual Framework project is from one perspec-
tive based on the entity concept but at the same time adheres to a proprietary
notion of defining performance and would base its accounting and reporting
standards on an implicit proprietary view of the firm.
Although few would dispute the value of having international accounting and
reporting standards, it is not clear that the IASB is deliberating and designing
international accounting standards and concepts in the international public inter-
est. The dominant influence of the FASB and earlier American conceptual frame-
work attempts is obvious. Is this the case because of their conceptual, theoretical
and methodological rigour, or because of the lack of an existing alternative? Or is
it perhaps because of the increasing strength of the shareholder model of corpor-
ate governance in international capital markets and the increasing strength of cor-
porate lobbyists in American, European and international politics? An
international accounting and reporting model based on a proprietary notion of
decision-usefulness and the asset – liability approach to income determination
does not take into account the different views of the company and its role in
different economic societies, and may contribute to international ‘negative
externalities’.
Giving primacy to the information needs of investors in equity and debt secu-
rities may have contributed to an externality in the form of the international
demise of the stakeholder model of corporate governance. Collusion between
management and investors in securities has increased opportunity for rent
seeking and moral hazard. Possible consequences include an exceedingly
short-term profit orientation, reduced corporate responsibility and accountability
to society, and increased income inequality within countries. Similarly, trading
off reliability for relevance may have caused another externality in the instability
of the international and national financial systems. Fair value accounting for
financial instruments without giving recognition to the role of financial account-
ing and reporting in the incentives for management to abuse off-balance sheet
entities, recognise, derecognise and leverage financial assets may have contri-
buted to irresponsible risk taking and a strong orientation towards short-term
performance indicators.
 210 C. van Mourik

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