GODFREY

HODGSON
HOLMES
TARCA

CHAPTER 8
LIABILITIES AND OWNERS
EQUITY

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
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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
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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
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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 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
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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

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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
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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
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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

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Liability recognition
Recognition criteria:
Reliance on the law
legal enforceability

Determination of the economic

substance of the event
real obligation

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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

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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

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

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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
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Employee benefits
pension (superannuation)
Unfunded commitments
plans
equitable obligations

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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
notes
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What impact will the credit crisis

have on the provision for bad debts
and the financial position of an
entity?

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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

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

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

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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)

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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
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Summary
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 setters
and auditors
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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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