The proprietary theory and the residual equity theory belong to a set of accounting concepts known as theories explaining equity. Though these theories are quite similar, varied applications of the proprietary theory result in different emphases as to proprietor’s net income.
Proprietary Theory in Accounting
The proprietary theory of accounting treats the owner of an enterprise as an extension of the firm itself and focuses on determining and evaluating the owner’s net worth. Basically, it assumes there is no separation between the business and its owner. As such, proprietary theory is most applicable to partnerships and sole proprietorships.
This theoretical framework is based on an equation: assets minus liabilities equal proprietor’s equity. In this formula, owned materials are assets, outstanding debts are liabilities, and net income equals revenue minus expense.
Corporations and Proprietary Theory
Proprietary theory can also be applied to corporations. In these cases, shareholders are treated as owners whose net worth is determined by total equity. From this perspective, corporate net income is calculated by treating interest and income tax as expenses that reduce net income to stockholders.
Residual Equity Theory
Residual equity theory assumes that a company's common stockholders are the true owners of a business. Therefore, any accounting must come from the perspective of shareholders.
Residual equity theory was developed by George Staubus of the University of California, Berkeley. It states that since preferred stockholders have no or limited voting rights, they are not the owners of the business. Therefore, to calculate residual equity, preferred shareholders and the claims of debt holders are subtracted from a company's assets. Preferred shares are considered a liability.
Read More: What Is Residual Equity?
Difference Between the Theories
Both the proprietary theory and the residual equity theory are based on the assumption of entities acting in a free economy. Both concern the ways in which accounting practices and techniques treat the assets and liabilities of proprietary groups or individuals. In these respects, the two theories are similar.
A significant difference between the two theories is that the residual equity approach does not include holders of preference share capital in the proprietary group. Instead as we have seen, dividends to preferred shareholders are deducted from net income before calculating residual equity holders’ dividend per share.
Read More: Characteristics of a Preferred Stock
The purpose of residual equity is to increase access to information for common shareholders so they can make informed investment decisions, as they do not receive payment preference if a company fails.
Other Equity Theories
Other equity theories include the entity theory, which, unlike the proprietary and residual equity theories, perceives the firm as a separate entity from the owners and capital providers. This approach is business-centered rather than proprietor-centered and treats income as the property of the business until its distribution to shareholders.
The enterprise theory takes the entity theory a step farther and considers the interests of various social groups as well as those of shareholders and creditors. These may include a company’s employees and customers, government agencies and society as a whole.
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