Rethinking the Concept of Equity in Accounting: Origin and Attribution of Business Profit

Table of Contents

1. Introduction

2. Firm’s Net Assets and Shareholders’ Equity

3. Shareholders’ Equity as the Residual Equity

4. Entity Equity as the Residual Equity

5. Who Are the Residual Claimants?

   1. Shareholders as the Sole Residual Claimants

   2. Other Residual Claimants Besides Shareholders

   3. Origin and Attribution of Business Profit

6. Conclusions

7. References

Accounting and Finance

1 Introduction

Accounting standard setters such as the Financial Accounting Standards Board (hereafter, FASB) and the International Accounting Standards Board (hereafter, IASB) typically do not make a sharp distinction between net assets, capital, and equity. In particular, shareholders’ equity is synonymous with a firm’s net assets under both FASB’s and IASB’s Conceptual Frameworks. However, equity originally involves a notion of a share or an appropriation, and accordingly an equitable distribution of business profit among its stakeholders (rather than claims on assets of a firm) should have been considered. The amount of equity (shareholders’ equity) cannot be necessarily determined uniquely even though the amount of net assets of a firm is determined. In other words, equity is essentially a relative concept and depends on a norm of profit distribution among stakeholders of a corporation.

AAA Committee on Foundations of Accounting Measurement (1971) recognizes two different categories of accounting:

One is accounting aimed at reconciling the equities of shareholders and other interested parties inside or outside an organization, in order to achieve an equitable distribution of the proceeds or benefits from operations. The other is accounting aimed at providing useful information for management and investor decisions, especially decisions concerning resource allocation. We shall call the former “equity accounting” and the latter “operational accounting.”

The perspective of this paper aligns with equity accounting, which supplies information affecting the distribution of payoffs generated by a firm, among various interested parties.

Ijiri (1975, pp. 32–34) regards accountability based on the recording and reporting of an organization’s activities as a valid objective of accounting and emphasizes on performance measurement, which affects the economic interests of the organization and its various stakeholders. According to Ijiri (1975, p. 35):

The conflict of interest that surrounds performance measurement is not limited to the relationship between the entity and the recipient of the entity’s performance measure. A conflict may arise between past and present shareholders after some shareholders sell their shares based on a poor earnings report. When there is a dispute over the maximum amount the corporation can distribute as dividends, the conflict may be between shareholders and creditors. Perhaps consumers will disagree with shareholders of a regulated corporation on a “fair” return on shareholders’ investment, or the corporation may vie with the Internal Revenue Service over taxable income, or divisions may challenge headquarters about incentive compensations that managers are entitled to receive based on divisional profit.

This paper emphasizes the notion of profit-sharing among interested parties, which is very consistent with Ijiri’s theory of performance measurement.

Also, Sunder (1997, p. 15) views the firm as a set of contracts among multiple agents; those contracts obligate each agent to contribute resources to the organization and, in return, entitle each agent to receive resources from it. He treats accounting as an accountability system that helps implement contracts among stakeholders and regards accounting income as the single most critical number (Sunder, 1997, pp. 20 and 61). Moreover, Littleton (1953, Chapter 2) considers income determination as the central purpose of accounting and explains justifications for the significance of information about enterprise income. According to Littleton (1953, pp.31–32), an income statement does not only provide the basis of most judgments about the value of the firm but also reports on the sharing of enterprise revenue among interested parties. These contributions to accounting theory bring us back to the fundamental problem: what equitable income measurement in corporate accounting should be like.

In this paper I regard equity as a claim to the fruits of investments, that is, a share in the excess of the funds recovered over the funds invested. Here the excess of the funds recovered over the funds invested represents net income or business profit, which is generated from a combination of resources including shareholders’ funds and non-financial investments by managers and employees. Under the current corporate accounting system, shareholders are assumed to be the sole residual claimants, who are entitled to the whole amount of net income. However, I assume in this paper that there are other residual claimants, specifically, employees and managers, in addition to shareholders, under implicit contracts, and reconsider the significance of the entity theory in corporate accounting.

The entity theory emphasizes an entity as an organization comprising various stakeholders and attributes business profit above shareholders’ expectations to an entity itself. If there are residual claimants other than shareholders, it can be argued that shareholders’ equity on a balance sheet and net income attributable to shareholders on an income statement are overstated under the existing corporate accounting system in which shareholders are assumed to be the sole residual claimants. In this paper I reconsider the concept of equity in corporate accounting from the perspective of the origin and attribution of business profit.

The rest of this paper is organized as follows. Section 2 reviews and compares the various definitions of equity which are presented by academic accountants as well as financial accounting standard setters. The issue here is the conceptual relations between a firm’s net assets and its shareholders’ equity. Section 3 distinguishes equity from net assets and then considers the proprietary theory, under which equity is identical to shareholders’ equity and the whole amount of net income earned by the corporation is supposed to be attributable to shareholders. Section 4 revisits the entity theory as explained by Anthony (1984). The entity theory limits income attributable exclusively to shareholders to the amount of the equity interest or the cost of using shareholders’ funds and views the residual income to be attributable to the corporate organization itself. Section 5 discusses the emergence of business profit and the recognition of the entity equity as distinguished from shareholders’ equity. Here the problem of who are the residual claimants is interpreted as the question of who contributes to the generation of business profit. Section 6 concludes the paper.

2 Firm’s Net Assets and Shareholders’ Equity

To begin with, we see how the FASB and the IASB define equity in their existing Conceptual Frameworks. Equity is defined as “the residual interest in the assets of an entity that remains after deducting its liabilities” in the FASB’s Statement of Financial Accounting Concepts No. 6 (SFAC 6) (FASB, 1985, paragraph 49). Also, in the IASB’s Conceptual Framework for Financial Reporting (IASB, 2018, paragraph 4.63), equity is defined as “the residual interest in the assets of the entity after deducting all its liabilities.” Both define equity as the difference between a firm’s assets and liabilities, so it can be said that equity is synonymous with or corresponds to the company’s net assets in their Frameworks.

Now we pay notice to the concept of assets which corresponds to the equity, assuming a firm with no liabilities. In the SFAC 6 (FASB, 1985, paragraph 25), assets are defined as “probable future economic benefits controlled by a particular entity as a result of past transactions or events.” The IASB’s Conceptual Framework (IASB, 2018, paragraph 4.3) also adopts almost the same definition as FASB’s.^[1] In regard to the essential characteristics of assets, SFAC 6 (FASB, 1985, paragraph 26) describes that “a particular entity can obtain the benefit and control others’ access to” an asset. In short, assets are future economic benefits controlled exclusively by the firm and therefore based on the concept of control. So, it can be argued that equity defined as an interest in assets is determined by the notion of control over assets, which also means that the right-hand side of a balance sheet is thought to represent claims against the assets rather than sources of funds invested in the assets.

Paton (1949) also views equities as claims on assets of a business enterprise. Paton (1949, p. 19) defines equities as the “equitable assignment or distribution of the total of the assets among the parties having rights therein which are subject to statement in monetary terms” and describes shareholders’ equity as the residual or “balancing” equity. Furthermore, assets are defined as “any factor, tangible or otherwise, owned by a specific business enterprise and having economic significance to that enterprise” (Paton, 1949, p. 15). It should be noted that Paton (1949, p. 26) claims “asset values can hardly be conceived entirely apart and distinct from equities therein” while equites are rights in assets and therefore there can be no effective equities without assets. Thus, equities and assets can be said to be two sides of the same coin. Paton’s view is different from that of the FASB and IASB Conceptual Frameworks in which assets are likely to be considered as independent of equity while equity is dependent on assets.

In contrast to the above discussion, both the existing FASB and IASB Conceptual Frameworks and the classic argument by Paton (1949) have in common that equity is defined as a right or an interest in assets of an entity. In either case, equity depends on the assets controlled by the firm and hence equity and assets on the balance sheet are inextricably linked. Emura (1959) calls this kind of equity the asset equity and also presents another concept of equity, which is named the capital equity.

The concept of capital equity is defined as an interest in invested capital (that is, the funds invested in a firm).^[2] It is based on the identity of capital providers and the amount of the provided capital to be maintained or recovered by the firm, and accordingly has no connection with assets on a balance sheet. Emura (1959) argues that the concept of equity cannot be simply dependent on assets on an entity’s balance sheet which only result from the transaction records by double-entry bookkeeping system.

The argument presented by Emura (1959) focuses on the correspondence relation between the capital and the equity, which directs our attention to the original meaning of equity in corporate accounting. Equity originally conceived in a branch of law, emerged and developed in England in the Late Middle Ages (when feudalism gradually waned) while the Lord Chancellor, according to justice and fairness, decided cases in which petitioners could not get remedies by common law. Above all, in the law of trusts made as part of equity, a trustee has the legal ownership of a property in trust while a beneficiary has an equitable ownership of the property. Then the trustee has a duty to care of and make use of the trust property for the benefit of the beneficiary. The law of trusts is said to have formed the basis of the corporate system in England (Chiba, 1991).

When a proprietor invests the property in a firm as capital for its enterprise, the entity is obliged to maintain and manage it for the benefit of the proprietor. In light of the trust doctrine, the legal ownership of the property invested as capital is attributable to the firm and the proprietor, as a beneficiary, holds the equitable interest or right in the capital. As for the modern joint-stock corporation, the equitable interest generally means the right to receive dividends of surplus and the right to receive distribution of residual assets, which shareholders acquire in exchange for paying financial capital in the company. This is the capital equity described above, that is, the equity which is linked with financial capital invested by shareholders. As noted earlier, the capital equity has no connection with assets controlled by a firm and hence the amount of it is not intrinsically determined uniquely by the value of assets on the balance sheet.

Whereas the FASB and the IASB consider equity as a synonym for net assets, the Business Accounting Council of Japan (BACJ, 2001, p. 14) defines equity as “an interest in or a claim to the results of business activities through an equity security (a share)” in the “Issue Paper on Accounting for Business Combinations” which was released in 2001. The equity defined by the BACJ is regarded not as a right in assets on a balance sheet but as a right in paid-in capital and profits earned (the results of investments). Therefore, it is close to the capital equity described earlier.

The Accounting Standards Board of Japan (ASBJ), in its discussion paper “Conceptual Framework of Financial Accounting” which was issued in 2006, distinguishes shareholders’ equity from net assets on a balance sheet. ASBJ (2006, Chapter 3, paragraph 7) defines the former as “a component of net assets attributable to shareholders who are the owners of the reporting entity (shareholders of the parent company in the case of consolidated financial statements).” Shareholders’ equity consists of the results of direct transactions with shareholders and the portion of the results of investments released from risks that is attributable to shareholders. The amount of shareholders’ equity is not necessarily equal to that of the firm’s net assets. For instance, unrealized holding gains and losses resulted from revaluation of assets and liabilities are excluded from shareholders’ equity even though they are components of net assets. This shareholders’ equity, distinguished from net assets, is almost equivalent to the capital equity as defined by Emura (1959). Table 1 summarizes the various definitions of equity and relations between assets and equity.

3 Shareholders’ Equity as the Residual Equity

On the basis of the viewpoint that distinguishes equity from net assets on a balance sheet, we see equity as a claim to the fruits of investments, that is, a share in the excess of the funds recovered over the funds invested. The central problem in the equity theory is: To whom should the results of corporate investment activities be attributed? Under the current corporate system, however, net income is supposed to be attributable exclusively to shareholders, and so is any retained earnings. Thus, prior to introducing the entity view of the corporation, we review the conception which is the base of the current system.

Husband (1954) regards a corporation as an agency organization for shareholders. Furthermore, Husband (1938) argues that “the corporation might well be viewed as a group of individuals associated for the purpose of business enterprise, so organized that its affairs are conducted through representatives.” The corporation is considered the agency or aggregation of shareholders who commit their funds for the purpose of obtaining profit, and the income earned by the corporation is in essence regarded as the income of the shareholders (Husband, 1954). In this perspective, the primary goal of accounting is to measure the entrepreneurial profit which serves as the driving force for the efficient functioning of free enterprise society, and the common shareholders are thought to occupy the entrepreneurial position (Husband, 1954). Therefore, all of the fruits of corporate investment activities should be attributable to the common shareholders who constitute the entrepreneurs. In contrast, Emura (1959) also views the corporation as the agency of shareholders, but he regards retained earnings reserves and voluntary reserves as the equity which is provisionally attributable to the company itself.

Although Paton and Littleton (1940) advocate the entity theory in their classic work, there still exists the basic thought that views a corporation as an agency for shareholders. Paton and Littleton (1940, p. 8) stress that “emphasis on the entity point of view, on the other hand, requires the treatment of business earnings as the income of the enterprise itself until such time as transfer to the individual participants has been effected by dividend declaration.” Their thinking contrasts with Husband’s (1954) view in that the income generation and distribution are distinguished; however, both of them think of the income earned by the entity as being eventually attributable to its shareholders. Indeed, while Paton and Littleton (1940) and Littleton (1953) emphasize the notion of the independent entity apart from shareholders, the results of the entity’s investment activities are supposed to be ultimately attributable to its shareholders and hence there still exists the agency or aggregation of individual participants’ point of view.

Penman (2003 and 2016 also develops an argument which emphasizes the common shareholders perspective like Husband (1954). He advocates, on the premise that ownership is separated from control, that common shareholders’ claims on the firm should not be obscured in the context of fiduciary duty of corporate directors and shareholders’ property rights. In addition, it is argued that making a clear distinction between common shareholders’ residual claims and other stakeholders’ claims provides relevant information for not only equity valuation but also credit analysis (Penman, 2016). Likewise, Staubus (1959) also explicates that putting a focus on the residual claimants, who are typically common shareholders, provides relevant information for other claimants such as creditors.

The entity theory, which is usually expressed by the equation, assets equal equities, divides equities in total assets of a firm into creditors’ equity and shareholders’ equity. Meanwhile, the residual equity point of view expounded by Staubus (1959) divides equities into specific equities and residual equity, and emphasizes the significance of the latter. More specifically, Staubus converts the conventional equation, assets = equities, to the following form:

where:

• Assets include the present cash balance plus future cash receipts that are considered reasonable definite, plus other things that can either contribute to cash receipts or reduce cash disbursements

• Equities include future cash disbursements plus other future relinquishments of assets

• Specific equities are liabilities, including preferred stock

• The residual equity is the equitable interest in organization assets which will absorb the effect upon those assets of any economic event that no interested party has specifically agreed to absorb

Specific equities in the left-hand side of this equation represent future cash disbursements to higher ranking equity holders from the firm, which correspond to liabilities. However, they include preferred stock as well.^[3]

The residual equity represents the claim of the most subordinated class of financial instrument holders and also provides a margin of safety or a buffer to all other equity holders. A change in a buffer equity and its balance should be of great significance to any equity holders and in this sense, the residual equity can be said to be the focal point of all investors’ interest (Staubus, 1959). Since the residual equity holders are normally common shareholders, the argument in which the residual equity is viewed as the central concept of accounting is in common with the proprietary theory that determines net income and equity from the shareholders’ perspective^[4]. However, it must also be noted that, in Staubus (1959), the residual equity is not distinguished from net assets on a firm’s balance sheet and the two concepts are synonymous. Therefore, once the amount of net assets is determined, the amount of the residual equity can be determined uniquely.

All of the literatures overviewed in this section, that is, Husband (1954), Penman (2003, 2016 and Staubus (1959), consider the measurement of shareholders’ equity (to be more precise, common shareholders’ equity) and its change as the primary objective of accounting. They all can be said to align with the proprietary theory. Under the proprietary theory, equity and its change are measured from the perspective of the residual claimants or shareholders who assume the ultimate risk of the results of corporate investment activities. In the next section, we overview the entity theory as explained by Anthony (1984), which contrasts sharply with the proprietary theory.

4 Entity Equity as the Residual Equity

Under the existing corporate accounting system, the proprietary theory is basically adopted, and the whole amount of net income earned by a corporation is supposed to be attributable to shareholders, and so is any retained earnings. Therefore, shareholders’ equity in accounting can be expressed as follows:

In this equation, funds provided by shareholders at time t-1 include any retained earnings at time t-1, and net dividends to shareholders in period t mean dividends plus share repurchases minus share issues in period t.^[5]

According to Anthony (1984), a corporation as an entity recognizes not only the interest cost of debt financing but also the cost of using funds supplied by shareholders, which is called equity interest.^[6] Furthermore, both costs are recorded as incurred expenses to the entity. The entity is considered to be independent of any fund provider and therefore both creditors and shareholders are nothing more than financial sources outside of the entity. Net income after equity interest in addition to debt interest cost is supposed to be attributable to the entity itself and the accumulated amount of it is called entity equity. Meanwhile, shareholders’ equity is defined as follows (Anthony, 1984, p. 78):

where:

• Equity interest is the cost of using funds supplied by shareholders

Shareholders are considered to have supplied additional funds to the extent that equity interest has not been repaid to them in the form of dividends (Anthony, 1984, p. 77).

Equity interest in a certain period of time is determined by applying a rate to the amount of shareholders’ equity at the beginning of the period. Anthony (1984, p. 82) argues that the equity interest rate should be either the entity’s pretax debt interest rate or a rate designated by the FASB. He attempts to measure the cost of using both debtholders’ and shareholders’ funds. The theoretically correct interest rate for measuring this cost is a weighted average of the aftertax debt and shareholders’ equity interest rates. The pretax debt interest rate overstates the real cost of using debtholders’ funds, but meanwhile, it correspondingly understates the cost of using shareholders’ funds. Anthony claims that applying the pretax debt interest rate as the rate for both debt and shareholders’ equity results in a satisfactory approximation of the true interest cost. As described above, the equity interest is recognized as an incurred expense and deducted from revenues regardless of whether or not the dividends are paid to shareholders. The difference between revenues and expenses including equity interest is net income, which is attributable to the entity itself.

Indeed, there is no perfectly reliable method to measure the cost of using shareholders’ funds or the expected return on shareholders’ investments, and hence, it is inevitable that estimates of equity interest will be subjective. In principle, financial reporting is supposed to provide the necessary information based on facts so that shareholders can infer the expected return from holding the shares, that is, it is thought that estimating the equity interest is not the role of accountants but shareholders. Under the entity theory, however, accountants need the explicit shareholders’ equity interest that is reliable to a satisfactory degree to measure net income attributable to the entity itself. It should be kept in mind that determining the shareholders’ equity interest will affect the distribution of income among stakeholders. Thus, at least, the method to determine the shareholders’ equity interest needs to be settled between shareholders and other stakeholders in advance, under the entity theory^[7]. Biondi (2012) also reevaluates the implications of the entity theory and shows various methods for allocating current earnings between shareholders and the entity. As Biondi (2012) points out, the method in which income attributable exclusively to shareholders (that is, shareholders’ equity interest) determined by a certain interest rate is just one of the alternatives for the income allocation between shareholders and the entity.

The entity theory explained by Anthony (1984) recognizes the cost of using funds provided by shareholders as an incurred expense to the entity in the same way as the interest cost of debt financing, which leads to the recognition that the residual equity is not shareholders’ equity but entity equity. It can be considered that the entity theory limits income attributable exclusively to shareholders to the amount of the equity interest or the cost of shareholders’ equity, and views the residual income to be attributable to the corporate organization. Under the proprietary theory, the residual income, which is defined as net income minus the expected return on the book value of shareholders’ equity, is supposed to be attributable to shareholders, whereas under the entity theory it is attributable to the corporate organization itself. Anthony (1984, p. 23) regards the entity as an organization, and seeks to measure the organization’s equity and the change in it rather than any particular party’s equity and the change in it.

A numerical example can illustrate the differences between the proprietary theory and the entity theory. Suppose that in order to start a business, a corporation raises currency units (CU) 480,000 by issuing common stock and borrows a CU320,000 loan with an annual interest rate of 5%. At the beginning of the accounting year, the corporation recognizes assets, CU800,000 (CU320,000 + CU480,000 = CU800,000); liability, CU320,000; and shareholders’ equity (paid-in capital), CU480,000, on the balance sheet. We suppose that sales revenue of the corporation is CU1,000,000, cost of sales is CU600,000, operating expenses are CU300,000, debt interest expense is CU16,000 (CU320,000 × 0.05 = CU16,000), and income taxes expense is CU25,200. Then, the income statement and the statement of shareholders’ equity for the period under the proprietary theory are as shown in Table 2(a) and Table 3(a), respectively.

Now assume that the equity interest rate, if it could be calculated, is 8% for the period and therefore the equity interest expense is CU38,400 (CU480,000 × 0.08 = CU38,400). In this example, the income statement, the statement of shareholders’ equity, and the statement of entity equity for the period under the entity theory are as shown in Table 2(b), Table 3(b), and Table 3(c), respectively. Under the entity theory, entity equity instead of shareholders’ equity is the residual equity, which is undistributed residual income attributable to the corporate organization consisting of multiple stakeholders, including managers, employees and others as well as shareholders. The undistributed residual income is then distributable to other purposes and stakeholders than remuneration for shareholders’ providing funds.

5 Who Are the Residual Claimants?

As we have seen in the previous section, the crucial distinction between the proprietary theory and the entity theory resides in the concept of residual equity. The proprietary theory views shareholders (or common shareholders) as the primary residual claimants and centers on the measurement of shareholders’ equity and its change. The entity theory, on the other hand, considers a corporate organization itself as the residual claimant, and divides shareholders’ equity under the proprietary theory into the limited shareholders’ equity and the entity equity as the residual equity. Regarding the income measurement, the entity theory limits income attributable exclusively to shareholders to the amount of the equity interest, and then deducts the equity interest from the proprietary theory’s net income. The residual is considered to be net income attributable to the corporation itself.

The Anthony’s (1984) entity theory recognizes entity equity explicitly and classifies the credit side of the balance sheet into three categories, that is, liabilities, shareholders’ equity, and entity equity. In this section, we discuss the significance of recognizing the third equity (entity equity). The problem is who ultimately take on risk of the results of corporate investment activities, in other words, who are the residual claimants.

6 Conclusions

In this paper, I have taken the view that the central problem in the equity theory in corporate accounting is to whom the results of corporate investment activities should be attributed. The focal point is the origin and attribution of ex post realized business profit, particularly of the excess of it over the ex ante expected return to shareholders. Of course, under the current corporate system, the excess profit is supposed to be attributable exclusively to shareholders.

Apart from the case where the excess profit emerges by chance and disappears shortly, one of the origins of the profit will be firm-specific investments by employees and/or entrepreneurial activities by managers. The questions like “Why does excess profit emerge?” and “Who has a claim to the excess profit?” lead to a reexamination of the concept of equity in corporate accounting. Unless shareholders are considered the sole residual claimants, it is crucially important to recognize the entity equity as distinguished from shareholders’ equity. From this point of view, shareholders’ equity on a balance sheet is misrepresented under the existing corporate accounting system in which shareholders are assumed to be the sole residual claimants. We should critically examine the foundation of the current corporate accounting in order to design a more equitable and efficient corporate accounting in which attribution of the results of corporate investments is determined according to contribution, and more specifically business profit above shareholders’ expectations is attributable not only to shareholders but also to other stakeholders who contribute to its generation.