Residual Equity Theory vs. Proprietary Theory

The proprietary theory and the residual equity theory belong to a set of accounting concepts known as theories explaining equity. Both are based on the assumption of entities acting in a free economy and both concern the ways in which accounting practices and techniques treat the assets and liabilities of proprietary groups or individuals, according to accounting textbook authors L.S. Porwal and Ahmed Riahi-Belkaoui. Though these theories are quite similar, varied applications of the proprietary theory result in different emphases as to proprietor’s net income.

Proprietary Theory

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. This theoretical framework, which Porwal describes as “placing the owner of an enterprise in the center of the accounting universe,” 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. Proprietary theory is most applicable to partnerships and sole proprietorships.

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

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, dividends to preferred shareholders are deducted from net income before calculating residual equity holders’ dividend per share. Residual equity theory was developed by George Staubus of the University of California, Berkeley. Its purpose 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. To calculate residual equity, the claims of bondholders and preferred shareholders are subtracted from a corporation’s assets.

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.