Eaquity Theories of Accounting

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Following is an income statement calculated based on the different equity theories of accounting.

Entity Theory
Proprietary TheoryOrthodoxUnorthodoxResidual Equity Theory Revenues $ 1,000,000 $ 1,000,000 $ 1,000,000 $ 1,000,000 Less:
Operating Expenses
Cost of goods sold $400,000 $400,000 $400,000 $400,000 Depreciation $100,000 $100,000 $100,000 $100,000 Salaries and Wages $200,000 $200,000 $200,000 $200,000

Operating Income $ 30,000 $300,000 $300,000 $300,000 Less
Bond Interest $80,000 $80,000 $80,000
Dividend on Preferred Stock $30,000 $30,000
Dividend on Common Stock $100,000

Net Income $220,000 $300,000 $90,000 $190,000

The proprietary theory assumes that owners and the firm are virtually identical. The entity theory states that the firm and the owners are separate entities. The residual equity theory claims that equity holders' rights are superseded by all other stakeholders of the company.

If the preferred stock were convertible at a ratio of two preferred shares for one shares of common stock, at the time of the conversion, there would be no preferred stock dividend to report. Therefore, under the residual method, net income would increase by the amount of dividend granted to the common stock. The unorthodox method would be affected in that it would shift the dividend on preferred stock to the dividend on common stock.

Evans, T. G. (2003). Accounting Theory: Contemporary Accounting Issues. Ohio: Thomson South-Western.

Schroeder, R. G., Clark, M. W., and Cathey, J. M. (2005). Financial Accounting Theory and Analysis, Text Reading and Cases: Eight Edition. New York: John Wiley & Sons, Inc.
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