An Overview Residual Equity Theory

There exist multiple equity theories such as proprietary theory, entity theory, enterprise theory, residual equity theory, and so on. Each of these approaches presents different beneficiaries of the net receipts and different perspectives on the ways to prepare accounting records. Residual equity theory presents an important approach for companies. It assumes residual owners as the beneficiary and emphasizes preparing accounts from their perspective. To comprehend the theory, it is important to understand the residual equity theory's meaning.

This article spotlights the meaning of residual equity theory, how it works and how was the residual equity theory developed.

Residual Equity Theory

The Residual equity theory considers common stockholders as the true owners of the company. The theory states that accountants should adopt a shareholder’s viewpoint. The residual equity calculated according to this theory gives the value that equity shareholders would receive if the company gets liquidated.

The residual equity theory can be placed somewhere between proprietary theory and entity theory. According to proprietary theory, business owners are not different from the business. The accounting records, according to this theory, are prepared from the viewpoint of the owners' group. However, the proprietary theory is more suitable for sole proprietary and partnership businesses.

On the contrary, entity theory assumes that a business entity has distinct existence from the capital providers. The receipts of a business, according to this theory, are its property until distributed among stockholders. Moreover, it states that the accountants should prepare the records from the business’s perspective.

As per residual equity theory, preference shares are the liability, instead of a part of a firm’s equity. This is because preference stockholders are repaid before common stockholders in case of company default. Equity shareholders have a right to remaining equity after debt holders and preferred stockholders get paid. Therefore, residual equity is identical to the Common stockof the firm. Equity shareholders are the residual investors. If the company incurs huge losses, the equity may disappear and bondholders and preference shareholders may become the residual investors.

The company is believed to continue the business for an indefinite time as per this concept. The value of equity relies on the expected future dividends which depend on the total receipts. The value remaining, after deducting the debt obligations, dividends to preferred stockholders, and reserves requirement, is the residual equity for common stockholders. Residual equity can give the idea of what common stockholders are worth against the risk taken.

The residual equity theory argues that the company shall make an additional effort for securing the interest of common stockholders. The theory also emphasizes that the equity shareholders should be provided with enough information about the corporate performance. They do hold the voting rights in the company, and this can help them make better investment decisions.

How does Residual Common Equity work?

Generally, debtholders are paid first if a company declares bankruptcy. Though, they do not have voting rights. Preference shares are treated as a hybrid instrument as they pay steady dividends. The preference shareholders either do not have or have limited voting rights. They get repaid once debt holders are paid.

The equity shareholders do not receive a fixed dividend. They are paid dividends after preferred stockholders. Additionally, they are the last to be considered in case of company default. As equity holders are liable to receive the remaining amount, after all the claims on the company’s income and assets are met, they are known as residual owners.

According to residual equity theory, the equity value of the firm is computed by deducting the debt obligations and preferred stock from assets, since preferred stocks are considered a liability. Additionally, the earnings-per-share calculation is only applicable to equity shareholders.

Residual Common equity = Assets - Liabilities - Preferred stock

The development of Residual Equity Theory

The Residual Equity Theory was developed by a financial accounting researcher named George Staubus, at the University of California. He states that financial reporting should provide important information to make investment decisions. This is the main aim of the decision-usefulness theory, which connected cash flows to assets and liabilities measurement for the first time. The theory was ultimately linked to Generally Accepted Accounting Principles (GAAP) and the Financial Accounting Standards Board framework.

To conclude, residual equity theory is one such equity theory that emphasizes more on the interest of residual owners, usually common stockholders. The theory assumes that they are the true owners of the business and their interests must be secured. According to this approach, preference capital is the liability for common stockholders. The capital remaining, after paying debt obligations, preferred stockholders, and other claims on assets belong to the equity shareholders

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Ans. The residual equity theory signifies the worth of common stockholders. The theory emphasizes that the company shall make an additional effort to secure the interest of common stockholders.