Residual Equity Theory

The theory of residual equity assumes that common shareholders are the true owners of a business. As a result, accountants must adopt their viewpoints. Preferred stock is a liability rather than an asset to common shareholders. Assets + Liabilities = Common Stock The statements of bondholders and preferred shareholders would be subtracted from the company’s assets to determine residual equity. Subsequent to deducting favored offers, just normal offers stay as the leftover value. This is the premise of the lingering value hypothesis, and normal investors can be considered as leftover financial backers.

The common shareholders of a corporation are usually the last to be paid any claims in the event of a business loss or bankruptcy, implying that they are the business’s fortress and the last line of credit to be repaid. In residual equity theory, residual equity is measured by subtracting a company’s assets from the statements of debtholders and preferred shareholders.

Residual Common Equity = Assets – Liabilities – Preferred Stock

Residual equity is also identical with common stock. Because of their status, the residual equity theory claims that common shareholders are the true owners of the company. The residual equity theory was founded by George Staubus, a professor at the University of California, Berkeley. As per Staubus, the basic investors of an organization ought to approach adequate data about the organization, including its money with the goal that they can settle on the best speculation decisions.

Staubus contributed significantly to decision-usefulness theory, which was the first to relate cash flows to asset and liability calculation. This method emphasizes data that is crucial in making investment decisions. The decision-usefulness theory was subsequently integrated into widely accepted accounting principles (GAAP) and the Financial Accounting Standards Board’s (FASB) conceptual structure.

The residual equity theory and the Proprietary Theory are utilized conversely. Basic investors are the rearward in line to be compensated if an organization declares financial insolvency, so Staubus accepted that we ought to compute value from their perspective. He argued that they should have access to enough information about a company’s finances and success in order to make informed investment decisions. As a result, the earnings-per-share calculation was created, which only applies to common stockholders.

The proprietary theory is firmly connected with sole ownerships and organizations as it thinks about the proprietor of a business or venture as an augmentation of the business. The remaining value hypothesis, then again, thinks about the basic investors of an organization as the genuine proprietors of the business. Proprietary theory is easier to grasp and fits well with sole proprietorships and partnerships. When investing in publicly traded firms, however, residual equity theory may provide a more accurate view.

There are other equity theories, such as the entity theory, which separates a business from its shareholders or creditors. The profits of a company are its property until it is allocated to shareholders, according to the entity principle. The needs of stakeholders such as workers, clients, government officials, and society are taken into account in enterprise theory.

Information Sources:

  1. thebusinessprofessor.com
  2. investopedia.com