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Course : F0812 Accounting Theory Year : February 2011

Liabilities and Owners Equity Session 7



Proprietary and entity theory

Proprietary theory is based on the idea that the owner is the centre of attention
accounting is done with the owners interests in mind

Entity theory focuses on the firm as the centre of attention

Proprietary theory
Proprietorship = net worth of owners = capital P=AL The objective of accounting is to determine the net worth of the owners Profit is the increase in net worth
includes operating profit includes changes in the values of assets

Proprietary theory
Present accounting is largely based on this theory
dividends salaries equity accounting consolidation accounting

Has a financial view of capital

emphasis on the financial investment of the owners and changes in owners wealth 6

Proprietary theory
With the advent of the company the theory has proved inadequate as a basis for explaining company accounting
developed when businesses were smaller a company is separate from its owners a company is a legal entity in its own right shareholders rely on managers for

Entity theory
Inadequacies in proprietary theory led to the entity theory Formulated to address separate legal status of company

Entity theory
The company is viewed as a separate entity with its own identity
separation of owners and managers accounting views the entity as an operating unit accounting principles and procedures not formulated in terms of an ownership interest can also be applied in proprietorships, partnerships and not-for-profit 9 organisations

Entity theory
The objective of accounting may be either stewardship or accountability
entity seen as being in business for itself interested in its own survival sees owners as outsiders reports to owners to meet legal requirements and maintain good relationships with them


Entity theory
Focuses on the assets Assets are resources controlled by the entity Liabilities are obligations of the entity Profit increases net assets and accrues to the entity The owners only have a residual claim on the net assets of the entity

Entity theory
Both proprietary and entity theories are still influential in practice
entity theory
conventional accounting theory based on it financial reports reflect it

proprietary theory
interest charges are an expense dividends are a distribution of profit


Liabilities defined
IASB Framework definition of liabilities: A present obligation of the entity arising 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

Past transaction
A past transaction (or event) ensures that only present liabilities are recorded and not future ones What kind of past transaction or event is acceptable?
wholly executory contracts


Liability recognition
Recognition criteria: Reliance on the law
legal enforceability

Determination of the economic substance of the event

real obligation


Liability recognition
Recognition criteria: Ability to measure the value of the liability
normally the nominal amount if period longer than 12-months, based on the present value of expected future cash flows

Use of the conservatism principle

at what point is the entity too conservative

IASB Framework
A liability should be recognised if
it is probable that any future economic benefit associated with the items will flow to or from the entity; and the item has a cost or value that can be measured with reliability


IASB Framework
What does probable mean? What is meant by reliable measurement?


Liability measurement
The Framework provides little guidance about how to measure liabilities A number of different measurement bases may be used Under IFRS, historical cost is the most common Fair value measurement is more commonly being used leases financial instruments share based payments business combinations

Employee benefits pension (superannuation) plans

Unfunded commitments
equitable obligations


Provisions and contingencies

Provisions and contingencies occur where there is a blurring between present and future obligations Liabilities and provisions are recognised only when there is a present obligation, it is probable and it can be reliably measured Contingent liabilities do not meet these criteria

What impact will the credit crisis have on the provision for bad debts and the financial position of an entity?


Owners equity
Framework defines equity as
the residual interest in the assets of the entity after deduction of its liabilities

Owners equity is a residual claim


Owners equity
Essential features Rights of the parties Economic substance of the arrangement


Concept of capital
Influenced by legal prescriptions
capital maintenance

Financial capital
invested money or invested purchasing power

Physical capital
the productive capacity of the entity

Capital can be measured on either a nominal dollar or purchasing power (real) scale


Classifications within owners equity

The distinction between contributed and earned capital is useful
retained earnings not all transactions fit nicely into categories
share dividends


Challenges for standard setters

IASB has several projects which will affect the definition, recognition and measurement of liabilities
debt versus equity distinction extinguishing debt employee shares (share-based payment)


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
evidence, timing, cut off concealment and understatement going concern overstatement - provisions reasonableness of fair values


There two competing theories that help explain accounting practice - proprietary and entity theories There are definitions for both liabilities and equity There are recognition criteria for both liabilities and equity There are various measurement practices used in relation to liabilities and equity There are challenging issues for standard 30 setters and auditors

Key terms and concepts

Liabilities Owners equity Proprietary theory Entity theory Definitions Recognition criteria probable, reliable Present obligation Past transaction Measurement and fair value Provisions and contingencies Rights of the parties Economic substance Concept of capital Debt versus equity, extinguishing debt and employee shares Issues for auditors



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