Perceptions of External Accounting Transfers under Entity and Proprietary Theory
Author(s): Francis A. Bird, Lewis F. Davidson, Charles H. Smith
Reviewed work(s):
Source: The Accounting Review, Vol. 49, No. 2 (Apr., 1974), pp. 233-244
Published by: American Accounting Association
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Perceptions of External Accounting
ransfers Under Entity and
Proprietary Theory
Francis A. Bird, Lewis F. Davidson, and CharlesH. Smith
and Flaherty' (S & F hereafter) have used a liquidity hypothesis
to describe "the method of assigning
values at the event of the exchange under
the historical cost system." Their finding
in general is that, in an exchange (a "twoway flow of goods . . . an acquisition accompanied by a sacrifice"), the more
liquid good is independently valued, and
the less liquid good is dependently valued.
They found, however, that their operational guidelines are inappropriate for numerous exchanges of nonmonetary goods.
Nichols and Parker2 (N & P hereafter)
subsequently took the liquidity hypothesis
to task by offering the objectivity hypothesis as an alternative: they found that
it "leads to practices recommended by the
majority view of the literature."
The objective of this paper is to demonstrate that accountants need to reach
unanimity on the fundamental question of
the nature of external accounting exchanges before guidelines can be completed
for the valuation of the "two-way flow of
goods." It is, in essence, our contention
that writers will continue to be at odds on
the issue of the method for attaching
values to the exchanges until agreement is
reached on the question of the nature of
the exchanges. The writers agree that a
valuation scheme is not complete unless
STERLING
developed for both internal exchanges, e.g.,
recording of depreciation, and external exchanges, e.g., recording of purchase of an
automobile. However, it seems reasonable
to conclude that most internal exchanges
are mere reclassifications of prior external
exchanges, and that it is therefore fundamentally more important to have an appropriate understanding of external exchanges.
The paper covers aspects of the overall
valuation problem, but it does not seek to
argue for or against the hypotheses of
The research for and writing of this paper were completed while Mr. Davidson was Assistant Professor of
Accounting at The University of Texas at Austin. The
Financial Accounting Standards Board, as a matter of
policy, disclaims responsibility for any publication or
speech by any of its individual members or staff. Accordingly, the views expressed here are those of the
author and do not necessarily reflect the views of the
Standards Board.
I Robert R. Sterling and Richard E. Flaherty, "The
Role of Liquidity in Exchange Valuation," THE AcCOUNTING REVIEW
(July 1971), pp. 441-56.
Donald R. Nichols and James E. Parker, "An Alternative to Liquidity as a Basis for Exchange Valuation,"
Abacus (June 1972), pp. 68-74.
2
Francis A. Bird is Professor of A ccounting at The University of Richmond, Lewis F.
Davidson is Research A ssociate with the
Financial A ccounting Standards Board, and
Charles H. Smith is A ssociate Professor of
Accounting at The University of Texas at
A ustin.
233
2T4
S & F and N & P. That debate is not entered into. The paper suggests, instead,
that the debate cannot be continued until
agreement is reached as to the nature of
the external exchanges entered into between the accounting entity and other entities, i.e., including legal owners.
Although the authors cited above use
the term "exchange," and although some
writers' appear to agree that, under the
conventional (historical cost) model, accountants admit exchange transactions as
the reportable input to the financial accounting system, for purposes of this paper
the term "transfer" is used to facilitate
description of exchange. The term "transfer" is more general, lends itself to subclassification and these subclassifications
can be used appropriately to describe the
nature of the more specific transfer known
as an exchange. More specifically, the discussion of this paper regarding the nature
of external exchanges is undertaken with
reference to the Accounting Principles
Board's (APB) categorization of external
transfers. In Statement No. 44 the APB used
external transfer to describe the basic input to the financial accounting system,
identified some of them as nonreciprocal
(nonexchange or one-way flow) in nature,
and was therefore forced to seek a more
general description.
The basic approach of this paper is to
illustrate the difference between the entity
and proprietary theories. The very fundamental question of what it is that accountants record cannot be answered until
agreement is reached as to for whom the recording is to be made. This implies a need
to settle the issue (pedestrian and prosaic
as it might seem) of entity vs. proprietary
theory. The ultimate development by accountants of a scheme for classifying and
recording external transfers is a function
of a viewpoint adopted, i.e., transfers of
resources or obligations between independent accounting entities (external trans-
The Accounting Review, April 1974
fers) may be perceived in accordance with
either the proprietary or the entity theory
of accounting.5 Different classification
schemes can result from such differences in
perception, and these can, in turn, lead to
different recordings.
The methodology of the paper will also
include an identification of the theory
(entity or proprietary) embraced by practitioners, and illustration of the fact that
current practices are often internally inconsistent, i.e., practice is based partially
on entity and partially on proprietary
theory. This will strengthen our basic argument that the S & F search for a set of
valuation guidelines will forever be frustrated until settlement of the entity vs.
proprietary issue is reached.
ENTITY AND PROPRIETARY
THEORIES CONTRASTED
The critical difference between the two
theories, at least insofar as external transfers are concerned, lies in the manner in
which owners' equity is perceived. Under
the entity theory, owners' equity is gen3 John J. Willingham,
Entity: A
(July
1964), pp. 543-52; William J. Schrader, "An Inductive
Conceptual Model,"
THE
"The Accounting
ACCOUNTING REVIEW
Approach to Accounting Theory,"
THE
ACCOUNTING
(October 1962), pp. 645-9; and W. A. Paton
and A. C. Littleton, An Introduction to Corporate Accounting Standards (American Accounting Association,
1940).
4 Statement of the Accounting Principles Board No. 4,
Basic Concepts and Accounting Principles Underlying
Financial Statemnents of Business Enterprises (AICPA,
1970).
C. Littleton, Structure of Accounting Theory
5 A.
(American Accounting Association, 1953), p. 25. Although argument can be made for a need to discuss
others, this paper is limited to issues under the two
dominant theories underlying financial statements, i.e.,
the proprietary and entity theories. The fund theory
has not generally been well received by accountants
seeking solutions to the problem of net income determination since it is not income oriented. The enterprise
theory is not at all well defined in scope and application.
Furthermore, the enterprise theory is value oriented
and therefore not applicable under the constraints of
historical costs. Under the residual equity theory the
residual equity is simply viewed" . . . as one of several
types of equity under the entity theory." Eldon S.
Hendriksen, A ccounting Theory (Richard D. Irwin,
1970), p. 501.
REVIEW
Bird, Davidson and Smith: External Transfers
erally acknowledged to be an obligation or
a liability of the enterprise to its owners,
albeit, "elastic and residual" rather than
"fixed and contractual" to use the distinction made by Paton in his Accounting
Theory.6 It is granted that the preceding
statement may be open to debate since, as
pointed out by Lorig, "some writers (on
entity theory) seem to want to maintain a
distinction between creditors and owners."
"However," Lorig goes on to say, "others
regard proprietors as creditors and the
widespread use of 'Liabilities' as a heading
for the whole credit side of the balance
sheet indicates that this is the commonly
held opinion."'
In conformity with the line of reasoning
which treats owners as creditors, the relevant accounting equation for the entity
theory is Assets= Liabilities.8 It is true
that this equation has evolved into the
more familiar entity theory equation,
and this fact has been
Assets=Equities,
commented upon by Gilman.
As early as 1917, Paton suggested replacing the
word "liabilities" with the word "equities." The
preference for the word "equities" seems a somewhat euphemistic attempt to avoid legalistic
235
viewpoint and in criticism of entity theory,
Sprague maintains that inclusion of proprietorship among the liabilities is improper since:
The entity does not stand in the same relation to
its proprietors or its capitalists as to its "other"
liabilities. It would seem more appropriate to say
that it is "owned by" rather than "owes" the
proprietors."2
Elsewhere,
Under the proprietary approach, the
enterprise
The accountant who bases his reasoning upon the
entity convention may, and frequently does, conceal that element of his working philosophy which
baldly asserts that an artificial entity owes money
to a proprietor for his investment and accumulated profits. But this may be due to no lack of
faith. Rather, it may be prompted by the desire to
avoid legal arguments.'0
In contrast to entity theory, proprietary
theory disavows that owners' equity is in
any sense a liability or an obligation of an
enterprise to its owners. Therefore, the
Assets= Liabilities equation is replaced by
one which treats owners' equity as a separate element, namely, Assets-Liabilities
= Owners' Equity." In defense of this
is viewed
as an agent
of the
owners and the records as an accounting
by the proprietors for their own property.
The owners are not considered outside
parties. This is in contrast with the entity
viewpoint which is concerned with the
examination of the operations of the entity
separate and apart from the suppliers of
funds.
PERCEPTIONAND CLASSIFICATIONOF
EXTERNAL TRANSFERS UNDER
PROPRIETARYTHEORY
reproach....9
Gilman himself supports the idea of treating owners' equity as a type of liability.
he states:
Thus the right-hand side of the balance sheet is
entirely composed of claims against or rights over
the left-hand side. "Is it not then true," it will be
asked, "that the right-hand side is entirely composed of liabilities?" The answer to this is that
the rights of others, or the liabilities, differ materially from the rights of the proprietors
In describing external transfers in StatementNo. 4, the position taken by the APB
is unquestionably "proprietary" since
owners' equity is denied any status whatsoever as a liability or obligation of the
enterprise to its owners. For example, in
6 William A. Paton, Accounting Theory (Chicago:
Accounting Studies Press Ltd., 1962), chapters 2 and 3,
and Stephen Gilman, Accounting Concepts of Profit
(Ronald Press, 1939), p. 58.
7 Arthur N. Lorig, "Some Basic Concepts
of Accounting and Their Implications," THE ACCOUNTING REVIEW
(July 1964), pp. 566-73.
8 Stephen
Gilman, Accounting Concepts of Profit
(Ronald Press, 1939), p. 57.
9 Ibid., p. 58.
10 Ibid., p. 64.
1' Hendriksen, p. 31.
12 Charles
E. Sprague, The Philosophy of A ccounts
(Ronald Press, 1913), p. 49.
13
Ibid., p. 46.
236
The Accounting Review, April 1974
discussing the situation in which the enterprise receives resources from owners, it
is stated that "the enterprise . . . incurs
no obligation in exchange for owners' investments." Also, throughout the Statement, reliance is placed upon the proprietary equation, Assets-Liabilities=Owners' Equity, with assets being defined as
"economic resources," liabilities as "economic obligations," and owners' equity as
"residual interest." Residual interest is
further defined as "the interest in the economic resources of an enterprise after deducting economic obligations."
With respect to external transfers,
Statement No. 4 identifies three types:
(1) Exchanges or reciprocal transfers,
(2) nonreciprocal transfers between an
enterprise and its owners, and (3) nonreciprocal transfers between an enterprise
and entities other than owners. It is not
possible to supply an answer to those concerned about the chicken and the egg issue.
It is safe to conclude though that the
APB's definition of the credit side of the
balance sheet and its categorization of external transfers are interrelated, i.e., embracement of either the definition or categorization as a starting point dictates acceptance of the other. Whether or not this
same classification scheme for external
transfers would have emerged had reliance
been placed on entity theory is the question to which attention is now directed.
PERCEPTION AND CLASSIFICATION OF
EXTERNAL TRANSFERS: ENTITY
THEORY VS. PROPRIETARY
THEORY
The discussion of this section will be
undertaken on the basis of the external
transfer categorization of proprietary theory, i.e., as developed in Statement No. 4.
Exchanges or Reciprocal Transfers
Exchanges are defined in the Statement
as "reciprocal transfers between the enterprise and other entities that involve obtaining resources or satisfying obligations
by giving up other resources or incurring
other obligations." There is no disparity
between this definition and the entity concept of exchanges. Both envision the situation shown in Figure 1.
Nonreciprocal Transfers Between an Enterprise and Its Owners
It is in the area of nonreciprocal transfers that the proprietary-entity cleavage
occurs. Nonreciprocal transfers are defined
in Statement No. 4 as "transfers in one direction of resources or obligations, either
from the enterprise to other entities or
from other entities to the enterprise." In
discussing "nonreciprocal transfers between the enterprise and its owners," the
Statement goes on to say:
These are events in which the enterprise receives
resources from the owners and the enterprise
acknowledges an increased ownership interest, or
the enterprise transfers resources to owners and
their interest decreases. These transfers are not
exchanges from the point of view of the enterprise.
The enterprise sacrifices none of its resources and
incurs no obligations in exchange for owners'
investments, and it receives nothing of value to
itself in exchange for the resources it distributes.
The foregoing quote in effect states that
an enterprise cannot enter into an exchange with its owners because it cannot
obligate itself to the owners. Concomi-
Resource or Release from
Obligation Received
Enterprise
^
Resource or Obligation Given
FIGURE 1
PROPRIETARY AND ENTITY THEORY
~~~~~~~~~~~Another
Entity
237
Bird, Davidson and Smith: External Transfers
tantly, when the enterprise distributes resources to the owners, it cannot receive a
release from any obligation to them.
This reasoning is in accord with proprietary theory. However, entity theory
would hold that the enterprise can indeed
obligate itself to its owners and receive releases from these obligations. Such entity
reasoning would then lead to the conclusion that "nonreciprocal transfers between
an enterprise and its owners" are exchanges no different in concept from exchanges with creditors. For clarification,
graphic depiction of the two viewpoints is
presented in Figures 2 and 3. Figure 3
(entity theory) covers both cases of Figure 2, and because entity theory views the
owners as separate from the enterprise,
the transfers consist of a two-way rather
than a one-way flow.
As specific examples of nonreciprocal
CaseI
Resources
Received
Enterprise
Owners
Onr
Resources
Given
Enter-
Owners
praise _'
Onr
FIGURE 2
PROPRIETARY THEORY: NONRECIPROCAL
TRANSFERS WITH OWNERS
CaseII
Resource
or
Release from
Obligation
Received
Enterprise
Resource
or
Obligation
Given
Owners
FIGURE 3
ENTITY THEORY:
EXCHANGES WITH OWNERS
transfers with owners, Statement No. 4
cites investments of resources by owners,
declaration of cash or property dividends,
acquisition of treasury stock, and conversion of convertible debt. Under the entity
theory, all of these would be considered
exchanges since, in each case, the reciprocity needed to qualify the transfer as an
exchange would be achieved by acknowledging either an obligation to owners or a
release therefrom.
It should be noted at this point that adherence to the proprietary viewpoint negates the idea that the rules of debit and
credit14 as applied to enterprise external
transfers can be succinctly stated as
"debit what is received" and "credit what
is given." Such a rule cannot be applied if,
as shown in Figure 2 above, the enterprise
can be involved in nonreciprocal transfers
in which it receives but does not give, or
gives but does not receive.
Nonreciprocal Transfers Between the Enterprise and Entities Other Than Owners
With respect to "nonreciprocal transfers between the enterprise and entities
other than owners," Statement No. 4 indicates: "In these transfers one of the two
entities is often passive, a mere beneficiary or victim of the other's actions.
Examples are gifts, dividends received,
taxes, loss of a negligence lawsuit, imposition of fines, and theft." Under proprietary
theory such transfers are perceived as depicted in Figure 4 which differs from Figure 2 only with respect to the description
of the transfer, i.e., the transfer correctly
covers obligations because entities other
than owners are involved.
Statement No. 4 cites the receipt of gifts
and dividends as examples of Case 1.
Gifts given, taxes, lawsuit losses, fines,
and thefts are cited as examples of Case II.
In contrast, entity theory, which acknowl14
Schrader, p. 648.
238
The Accounting Review, April 1974
Case I
Resource or Release
from Obligation Received
Enterprise
,I1Owners
Case II
R
r or
Resource
Given
_
Enterprise
_
An Entity
Other Than
An Entitv
Other Than
~~~~~~~~~~~Owners
FIGURE 4
PROPRIETARY THEORY
edges obligations to owners and releases
therefrom, might explain all of these examples (except perhaps dividends received
and taxes, discussed later in this paper) in
the manner shown in Figures 5 and 6.
Gifts to and from the enterprise can be
used to provide examples of Figures 5 and
6. A gift which is received by the enterprise from an entity other than owners
would be counterbalanced by the enterprise giving a commitment or obligation to
its owners. (Entity theory advocates
would argue that a maturity date is not
essential for the creation of a liability, and
that the nature of this particular commitment is very simply a promise to make
available and/or pay over to owners the
proceeds of the gift upon realization.)
Correspondingly, a gift given by the enterprise to an entity other than owners
would be counterbalanced by the enterprise receiving a release from its outstanding commitment or obligation to its owners. Similar reasoning can be applied to
lawsuit losses, fines and thefts.
Summary
What is being suggested at this point is
that entity theory easily accommodates an
expanded concept of exchanges, namely,
one involving three parties with the enterprise acting as receiver from one party and
< ) <&t1
X & vAn
FIGURE
A
7
5
GIFT TO THE ENTERPRISE
Received
Releaseobligation
Enpise
Resouce Given
FIGURE
A
Entit
6
GIFT FROM THE ENTERPRISE
Ower
Bird, Davidson and Smith: External Transfers
giver to another. Thus, under entity
theory, two types of exchanges'5 could be
identified: (1) those involving the enterprise and one other party (bilateral) as
shown in Figures 1 and 3, and (2) those
involving the enterprise and two other
parties (trilateral) as shown in Figures 5
and 6. In trilateral exchanges, just as in
bilateral, the previously mentioned observation that debit and credit equate to
receiving and giving, respectively, would
still be valid.
If the reasoning above is accepted, all
the examples of "nonreciprocal transfers
between the enterprise and entities other
than owners" given in Statement No. 4, and
cited in the preceding paragraph, would be
designated trilateral exchanges under entity theory except perhaps for the two
examples of taxes and dividends received.
Both of these examples could be construed
as bilateral exchanges. In the case of taxes,
it could be contended that the enterprise
gives a resource or obligation to the government in return for the receipt of government services. With respect to dividends
received, the reciprocal element given
could be said to be entrepreneurial services
furnished to the entity paying the dividend.
To summarize, external transfers as perceived under proprietary and entity reasoning can be contrasted as shown below.
Proprietary
1. Reciprocal transfers or exchanges
2. Nonreciprocal transfers between an enterprise and
owners
3. Nonreciprocal transfers between an enterprise and entities other than owners
Entity
1. Bilateral exchanges
itsI
2. Trilateral exchanges
IMPLICATIONS OF THE DIVERGENT
PERCEPTIONS
As perceived under the entity theory,
all external transfers are exchanges involving simultaneous reciprocal flows of
consideration to and from the enterprise.
Under the proprietary theory such is not
239
the case because nonreciprocal transfers
are identified which involve a one-way
flow only, either to or from the enterprise.
This basic difference in perception may
have significant implications for accounting thought.
Rules of Debit and Credit
At a very fundamental level, the basic
rules of debit and credit can be stated differently depending upon the way in which
external transfers are perceived. As indicated previously, the rule for external
transfers under entity theory can be
stated very concisely as "debit what the
entity receives" and "credit what it
gives." A proprietary theorist would find
this rule unacceptable because it does not
accommodate nonreciprocal transfers. His
debit-credit rules would be the familiar
ones which stress increases or decreases in
the three components of the proprietary
balance sheet equation, as expanded so as
to include income statement accounts as
subelements.
Examples: Differences in Perception Only
As a logical extension of different thinking at the debit-credit level, further divergences in accounting thought may result at higher levels. For example, with respect to the concept of revenue, Hendriksen states:
Two approaches to the concept of revenue can be
found in the literature, one focusing on the inflow
of assets resulting from the operational activities
of the firm and the other focusing on the creation
of goods and services by the enterprise and the
transfer of these to consumers or other producers.
That is, revenue is considered to be either an inflow of net assets or an outflow of goods and
services.16
As a matter of conjecture, it would seem
that an entity theorist, emphasizing the
15 It is clear from the above discussion that transfers
under entity theory are all exchanges. This latter term
is therefore used rather than the more general term,
transfer.
16
Hendriksen, p. 160.
240
reciprocal flows which to him are always
present in external transfers, would identify revenue as an outflow of goods and
services. On the other hand, a proprietary
theorist, conditioned as he is to think of
external transfers more in terms of their
ultimate effects on the balance sheet,
might reason that revenue is an inflow of
net assets which is counterbalanced, ultimately, by an increase in owners' equity.
As in the case of revenue, the concept of
cost may be open to different interpretations. Just as it would seem reasonable for
an entity theorist to define an outflow of
goods and services as revenue or revenue
realization, it would also appear reasonable for him to define its counterpart, an
inflow of goods or services, as cost or
cost incurrence. It is doubtful, however,
whether a proprietary theorist would define cost as an inflow of goods or services.
It is more likely that his perception of cost
would be in accord with the following
statement made by Hendriksen:
What is meant by cost and what should be included in the term? Basically, cost is measured by
the current value of the economic resources given
up in obtaining the goods and services to be used
in operations.'7 (Emphasis added)
Turning to the more practical implications of the divergent perceptions of external transfers, one becomes aware of an
important difference in thinking between
entity and proprietary adherents in connection with the recording process. Since
the "entity accountant" perceives all external transfers as exchanges, he must
identify each of two reciprocal flows (received and given) in order to confirm that
a recordable external transfer does, in fact,
exist. On the other hand, the "proprietary
accountant," because of the existence of
nonreciprocal transfers in his frame of
reference, need only identify one flow. Consider, for example, the case of taxes which
is cited in Statement No. 4 as an example of
a "nonreciprocal transfer between an en-
The Accounting Review, April 1974
terprise and entities other than owners."
In this case, Statement No. 4 acknowledges
only that a resource or an obligation is
given by the enterprise. Therefore, the
question of exactly what the debit to tax
expense represents is left unanswered.
However, an entity adherent, because his
thought process is centered on reciprocity,
would strive to identify both the "received" and "given" elements and, as a
matter of conjecture, it would seem likely
that he would identify the debit to tax expense as "government services received."
Based on the foregoing observations,
the following generalization will now be
advanced: The proprietary accountant,
because he is not constrained by the necessity to identify reciprocity in external
transfers, might admit on occasion to the
accounting record data which would not be
recorded by his entity-thinking counterpart. As one example, consider the recording of a receipt of stock subscriptions
counterbalanced by a credit to capital
stock subscribed. To the entity accountant, this would be an exchange of reciprocal obligations and, therefore, executory in
nature and generally nonrecordable under
present-day accounting conventions. However, to the proprietary accountant such
an entry might be acceptable since it
could be thought of as a nonreciprocal
transfer involving the receipt of a resource
by the enterprise. In other words, the fact
that proprietary theory holds that an enterprise cannot obligate itself to its owners
(presumably either current or prospective) removes the stock subscription entry
from the "reciprocal obligation" category
and places it in the nonreciprocal category.
Reasoning parallel to the above can be
applied in other areas such as the recording
of a stock option at the date of grant when
the option is given for future services.
It is also possible that the proprietary
17
Ibid., p. 181.
Bird, Davidson and Smith: External Transfers
accountant might record some "external
transfers" which would be considered fictional by his entity-thinking counterpart.
For example, a common practice in connection with warranty guarantees is to
record the sale and then to make a complementary entry charging warranty expense
and crediting an estimated liability for
future warranty service. A proprietary accountant might accept this treatment as
correct since he could view the sale as a
reciprocal transfer and the expense entry
as a nonreciprocal transfer. However, an
entity accountant probably would reason
that the nonreciprocal transfer is fictional
since the debit to expense represents
nothing received. To his way of thinking,
proper reciprocity would be shown if the
expense debit of the second entry were
netted against the original sales credit and
the two entries compressed into one exchange entry. This exchange entry would
reflect a resource received offset by two
elements given, goods (sales) and a promise to provide future services (liability).
Consider further the unresolved problem of the proper treatment of payments
for the use of capital. This problem has
long been a thorn in the side of accounting
theorists. The controversy which raged
during the 1920's was perhaps one of the
most intense in accounting history with
some 234 references in the Accountant's
Index during the period of 1900-1926. The
problem centers on the question as to
whether interest is a cost or a distribution
of income somewhat akin to dividends. If
it is a cost, should it be subjected to the
internal reclassification in the same manner as other costs such as labor, materials,
or overhead? That is, does interest cost become a bona fide component of inventory
cost or constructed assets? To include
interest cost on only debt capital, whether
general or specific debt, is to permit the
capital structure and management discretion on identification of funds to influ-
241
ence asset cost unless interest is imputed to
owner's capital. Since for the proprietary
theorist the credit for such an imputed
charge would necessarily be to interest income, it would violate the realization
principle to the extent that the charge was
deferred in the balance sheet. The issue
was temporarily resolved by requiring
treatment of interest as a period charge in
the case of debt capital concerning operations. However, interest on constructed
assets remains a much debated issue, with
current practice being generally to capitalize interest on specific debt on the constructed asset (with the implicit assumption that such identification is possible).
Public utilities continue to capitalize all
interest including that on owner's capital,
with the credit being to interest income.
The problem of interest can be perceived
quite differently from the entity point of
view which recognizes obligations to
owners and creditors alike. To the entity
theorist there is no question to the fact
that payment for the use of capital is a
cost since a service (use of money) has
been received in exchange for obligations
to the suppliers of capital, whether it be
creditors (liabilities) or to owners (equity).
From the entity theory viewpoint there is
a bona fide exchange which permits the
recognition of interest cost both for debt
capital and equity capital. Moreover, the
credit for the imputed interest charge on
owner's capital is an obligation to owners,
i.e., a credit to equity, and not to interest
income. Note that revenue or income is
defined as an outflow of goods or services
rendered by the entity. Such is not the
case with this credit; it is merely the
recognition of an obligation analogous to
interest payable for debt capital. The payment of actual interest is cash given in exchange for release from obligation. Analogously, the payment of dividends is not a
distribution of income but is cash given in
exchange for release from obligations.
242
Examples: Recording Differences
Although the previous sections reveal
that proprietary and entity theories perceive external transfers differently, it is
clear from the section immediately preceding that such differences in viewpoint
do not necessarily have serious results, i.e.,
the net effect of recordings can be similar
irrespective of viewpoint. This is, unfortunately, not always the case. It is the differences in the net effect of recording that
force the writers to the conclusion of this
paper, i.e., that unanimity needs to be
reached on the fundamental question of
the nature of external transfers (and therefore settlement of the proprietary vs. entity theory issue) before valuation guidelines can be set for the recording process.
Because the assets of an enterprise are
perceived under proprietary theory as belonging to owners, Hendriksen correctly
states that "proprietorship is considered to
be the net value of the business to the
owners."18 Proprietary theory is therefore
a wealth concept. One could conclude
therefore that proprietary theory leads to
a need for current value accounting. It is
extremely doubtful that an entity accountant, indoctrinated as he is with the
concept of exchange reciprocity, would be
agreeable to the idea of current value accounting.'9 To his way of thinking, no reciprocal giving and receiving has occurred
at the current market level, and therefore
admission of market value to the accounting record is unjustified. The proprietary
accountant, however, may be more receptive to the idea since he is already conditioned to the recording of what he perceives to be nonexchange or nonreciprocal
data.
On the other hand, and somewhat paradoxically, the entity accountant, while he
would not agree to market value as a
proper basis for carrying securities, might
agree to the equity basis for investments in
common stock of less than majority-owned
The Accounting Review, April 1974
companies. To elaborate on this statement,
an increase in the investment in stock
account would represent an additional
commitment or obligation received from
the owned company and the offsetting
credit to income would be reflective of
entrepreneurial services given to that
company. There is logical parallelism here
since, if the entity accountant were to consider entries made on the books of the
owned company, he would think of the
entry which transfers net income to retained earnings as a debit to services received from owners and a credit to commitment or obligation given to owners. However, the proprietary-thinking accountant,
because he does not acknowledge that'an
enterprise can obligate itself to its owners,
would not accept this line of reasoning.
His acceptance of the equity method, if
indeed he accepted it, would probably be
based on either the concept of current
value or partial consolidation.
Convertible debt provides another useful example of an unsettled issue. The two
basic theories lead to different recordings,
and both are to be found in practice today.
The proprietary theorist, reflecting concern for the affairs of the owners, would in
all likelihood support the recording of a
gain or loss at the time of conversion. The
entity theorist would probably argue that
an additional exchange in form only has
occurred at the time of conversion (the
liability before and after conversion is unchanged), and the only change of substance that is required is that of account
descriptions, i.e., use of the so-called book
value method which does not reflect a gain
or loss.
Ibid., p. 496.
19Price level adjustments could conceivably be acceptable to the entity accountant, but not current exchange (entry or exit) values. The former adjust for a
change in the value of the measuring unit, but not that
of the resources or obligations involved in the original
exchange.
18
Bird, Davidson and Smith: External Transfers
THE INTERNALINCONSISTENCIES
OF
CURRENTPRACTICE
This paper argues that valuation guidelines under the historical cost model cannot be developed until a decision is made
to embrace either proprietary or entity
theory. It also argues that the development of such guidelines is not possible on
the basis of "an observation of practice"
because current practice reflects use of
both proprietary and entity theories. Embracement of two fundamentally different
underlying theories is bound to lead to a
mixed set of guidelines.
In listing and describing the generally
accepted accounting principles contained
in Statement No. 4, the APB indicated that
"The description of generally accepted
accounting principles is based primarily on
observation of accounting practice." Statement No. 4 is, then, a summary of what accountants were doing as recently as 1970.
If Statement No. 4 represents a description
of current practice, it is clear (from the discussion of Statement No. 4, and from observation and analysis of numerous current practices) that the very foundations
of current practice are internally inconsistent, and that guidelines for practice are
developed on the basis of both proprietary
and entity theories.
Earlier in this paper it was observed
that Statement No. 4's position is proprietary in nature in that owners' equity is
denied any status as a liability of the enterprise to its owners. And yet the principles
section of Statement No. 420 evidences implied acceptance of entity theory because
of the reliance upon historical cost as a
valuation method. The Statement adopts
a proprietary theory perception of the
transfers in the concepts section, but entity theory's valuation method is dominant in the principles section. In the
previous section of this paper it was indicated that proprietary theory leads logically to different bases for asset valuation
243
in order to value more accurately the
wealth of owners. It is not unjustified
therefore to ask those who purport to embrace proprietary theory why the main
basis for asset valuation continues to be
historical cost.21 The latter is logically acceptable under entity theory.
It is also necessary to ask those who purport to embrace proprietary theory how
they are able to justify use of the equity
method and 100% elimination of intercompany profits in consolidations, both of
which are entity theory phenomena.
Entity theory suggests that, for the
profits made by a subsidiary, an exchange
has occurred between the parent and the
subsidiary (the parent has received a
promise from the subsidiary for payment
of profits made, and this promise is made
in return for use of the parent's funds and
for assumption of risk on the part of the
parent), and therefore use of the equity
method is justified. Use of the equity
method cannot logically be argued under
proprietary theory because this theory
does not recognize a promise, commitment, or obligation to the parent (stockholder) with respect to the subsidiary's
profits.
With respect to consolidations two principal alternatives exist for the elimination
of intercompany profits, namely, the fractional and 100% elimination methods. The
fractional method draws a sharp distinction between classes of equityholders (the
majority and minority interests) since
only the proprietary (majority) share of
the intercompany profit is eliminated. The
minority interests' share of this profit is
recognized as a liability. On the other
20 Statement No. 4 is made up of a concepts section
(chapters 3-5), and a description of current principles
section (chapters 6-8).
21 One should hasten to observe what could be interpreted as a slight trend in practice in the direction of
current value accounting. The use of the Equity
Method (APB Opinion No. 18) and proposal of the
APB to value marketable securities at current values,
are examples.
244
The Accounting Review, April 1974
hand, the 100% elimination method requires that no distinction be made between these two groups. Under this
method no intercompany profits are recognized as accruing to either the majority or
minority interests. Despite the fact that
Statement No. 4 embraces proprietary
theory (with which the fractional method
is consistent), the prevailing practice of
100% elimination is based upon entity
theory.
Practice also employs different recordings for the retirement of similar financing
obligations. The first case to be looked at
is that of a gain upon the retirement of
debt which finds its way into the income
statement as proprietary theory would
dictate. However, a gain on the retirement
of preferred stock is credited to a separate
owners' equity account as is dictated by
entity theory. The latter would, of course,
accord to debt the same treatment as that
accorded to preferred stock because the
difference, or gain, in both cases constitutes a direct change in owners' equity
(increase in the obligation to residual
equity holders) rather than income to
stockholders." The second case of relevance under this heading of financing obligations is that of the retirement of convertible debt which was discussed in the
previous section. The book value and
market value methods are acceptable in
practice, and yet the former is dictated by
entity and the latter by proprietary
theory.
SUMMARY AND CONCLUSION
The findings of this paper are that:
1. Adoption of proprietary theory results in a different perception and classification scheme of external transfers than
does adoption of entity theory.
2. Proprietary theory views certain external transfers as being nonreciprocal in
nature, whereas entity theory views all
external transfers as exchanges between
entities.
3. While the differences in perception
do not often lead to differences in the net
effect of recordings, there are a number of
situations where recordings are different in
terms of effect on the financial statements.
4. Practitioners purport to embrace
proprietary theory, but examination of
current practice leads to the conclusion
that recordings are sometimes based on
proprietary and sometimes on entity
theory.
Two specific conclusions appear to follow from the findings:
a. If accountants could reach unanimity
on the very fundamental question of the
nature of external accounting transfers, it
would lead to acceptance of either proprietary or entity theory as a major underlying concept. The result of this choice
would be the development of accounting
thought and practice which would be internally consistent. Differences in such
thought and practice would therefore be
narrowed.
b. It is incorrect to describe the conventional (historical cost) model on the basis
of an examination of current practice. Attempts such as those of S & F and N & P
to develop valuation guidelines therefore
will forever be frustrated until the proprietary vs. entity choice has been made.
22 Under the entity concept, despite the fact that
they rank differently from a legal point of view, shareholders and debtholders are viewed equally as providers of enterprise capital. For this reason, under the
entity concept, income to all investors includes interest
on debt, dividends on preferred stock, dividends on
common stock, and all the undistributed remainder.
The 1957 Statement of the American Accounting Association, in explaining the entity concept, stated that,
". . . interest charges, income taxes, and true profitsharing distributions are not determinants of enterprise net income" See, Committee on Accounting Concepts and Standards, "Accounting and Reporting
Standards for Corporate Financial Statements" (Columbus, Ohio: American Accounting Association, 1957),
p. 5. The implication of all this is, of course, that income
can exist under entity theory only if one imposes a
particular viewpoint upon the entity, e.g., all stockholders versus all equity holders versus residual
claimants.