Case 15-12 Debt Versus Equity

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Case 15-12 Debt versus Equity

Case 15-12 Debt versus Equity
Discuss the entity theory rationale for making no distinction between debt and equity. The entity theory was among the first new theories of ownership. (Schroeder, Clark, & Cathey, 2009, page 499). It depicts the accounting equation as assets equals equity (Schroeder, Clark, & Cathey, 2009, page 363). It makes no distinction between debt and equity (Schroeder, Clark, & Cathey, 2009, page 500). Entity theorist believe that companies’ accounting should be prepared from the accounting entity’s view instead of in the interest of the shareholders. According to the entity theory, there is no fundamental difference between liabilities and owners equity. Both provide capital to the business entity and receive income in return in the form of interest and dividends (Schroeder, Clark, & Cathey, 2009, page 363). Under entity theory, liabilities and equity would require separate line disclosure in the balance sheet, but there would be no subtotals for total liabilities or total equity. (Schroeder, Clark, & Cathey, 2009, page 363). Both are considered a source of capital, and the operations of the firm are not affected by the amount of the debt relative to equity (Schroeder, Clark, & Cathey, 2009, page 500). Under the entity theory, debt-to-equity ratios would not provide relevant information for investor decision making (Schroeder, Clark, & Cathey, 2009, page 500). Present accounting practice makes a sharp distinction between debt and equity (page 500). The recent exposure draft and SFAS No. 150 makes it evident that FASB favors the position that balance sheets should distinguish between debt and equity (page 500). The

Is entity theory or proprietary theory consistent with modern theories of finance- that is, does the firm’s capital structure make a difference? Explain. There are two types of equity theories: entity theory and proprietorship (page 498). The purpose of a theory is to...
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