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 = A-L
• 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
 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 information
 no longer so relevant
 ENTITY THEORY

• Martin outlined two assumption as the idea in accounting :

• 1. separation
• 2.Viewpoint.
 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
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
 2 VERSION OF ENTITY THEORY

• Traditional Version
• Newer Interpretation
 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
1. conventional accounting theory based on it
2. financial reports reflect it
 proprietary theory
1. interest charges are an expense
2. 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 obligations
 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:
1. Reliance on the law
2. Determination of the economic substance of the event
3. ability to measure value of the liability
4. Using conservatism principle