TUTORIAL SOLUTIONS CHAPTER 8

QUESTIONS

1. With respect to the proprietary theory:

(a) What is the objective of the firm?
(b) How important is the concept of ‘stewardship’?
(c) What is the relationship between assets/liabilities and the owner?
(d) How would you define revenues, expenses, profit?
(e) What are three effects on current practice?
(f) What are the theory’s limitations?

(a) The firm essentially is the proprietor. The firm is simply the proprietor’s
instrument to achieve his or her purpose, which is to increase his or her wealth.
Income represents the increase in the wealth of the proprietor in a given period.

(b) Stewardship is relatively unimportant, because accountability to outside parties is

not critical. The proprietor is, in effect, the firm, and therefore is in a privileged
position to know what is happening. Liabilities are usually short term, and
therefore there is no need to give a continual accounting to creditors.

(c) The assets are ‘owned’ by the owner, and the liabilities are ‘owed’ by the owner.
This shows that there is no separation between the firm and the owner. In the
accounting equation, P stands for the net worth of the owner.
A–L=P

(d) Revenue is the increase in proprietorship; expense is the decrease in

proprietorship; and profit is the net effect of proprietorship, excluding additional
investments and withdrawals by the owner. Revenue and expense accounts are
truly subsidiary accounts of P. They have the same algebraic characteristic as ‘net
worth’ — increases in net worth are credits and decreases in net worth are debits.
The proprietary theory focuses on P in viewing income. Revenues and expenses
are caused by the decisions and actions of the proprietor. The profit of the firm
belongs to the proprietor and that is why P is affected in the accounting equation.

(e) The following are examples of the effect of the proprietary theory on accounting
practice:
 Dividends paid are a distribution of earnings, not an expense; and interest
charges are an expense.
 In a sole proprietorship or partnership, salaries to owners who work in the firm
are not considered an expense of the business. The reason is that the firm and
the owner are not separate entities; they are the same.
 The equity method for long-term investments focuses on the proprietary interest
of the investor company in the invested company.

1
  The parent company theory for consolidating financial statements views the
parent as ‘owning’ the subsidiary. Minority interest is considered an ‘outside’
claim, and logically should therefore be a liability on the consolidated
statement of financial position.
 The pooling of interests method for business combinations emphasises the
uniting (pooling) of the owners’ interests of the two combining companies.
 Common terms used reveal the proprietary interests of owners are: book value
per share, earnings per share and income to shareholders.
 The use of the consumer price index for general price level adjustments shows
that the ‘consumer desires’ of owners are considered.
 The financial capital view is pertinent to owners.

(f) The proprietary theory does not accord with the realities of the large corporation.
The law recognises the corporation as a separate entity, distinct from the owners.
The corporation — not the shareholders — owns (controls) the assets, and is liable
for the debts. For the large corporation, withdrawals of cash or other assets by
shareholders cannot be made without running afoul of the law. This shows that the
ownership rights of shareholders are limited. Accountability to shareholders is
significant; otherwise, shareholders have no knowledge of the status and
operations of the business. The assumptions of the proprietary theory are not
relevant to the shareholders of large firms.

2. With respect to the entity theory:

(a) What are the reasons for concentrating on the entity as a unit of
accountability rather than the proprietor?
(b) What is the objective of accounting?
(c) How important is the concept of ‘net worth’?
(d) What is the reason for modifying the accounting equation to
Assets = Equities?
(e) On what side of the equation in (d) would retained profits appear?
(f) Why is there a stress on profit determination?
(g) How do the concepts of revenues, expenses and profits differ from the
proprietary theory? What about interest charges, dividends and income tax?
(h) What are three effects on current practice?

(a) Emphasis is on the entity, because in the 20th century the separation of owners
from management in the corporate form of business is common. Shareholders of
large corporations have little power to make decisions for the company. The
corporation, the entity, has a life of its own. It is therefore more realistic to view
the entity as the unit of accountability — that is, to see the accounting process
from the point of view of the entity. It is the entity (through its management) that
has the power to make decisions that affect the financial status and operations of
the business.

(b) Stewardship or accountability to equityholders is of primary significance. The

entity needs to account to those who have supplied funds (shareholders and
creditors). There are two views of entity theory, but both stress accountability to
equityholders. The conventional view emphasises stewardship because

2
 equityholders are seen as ‘associates’ in business. The newer view focuses on
stewardship because of legal, contractual requirements, and also to maintain good
relations with equityholders in the event of the company needing more funds.

(c) The net worth of the owner is not a meaningful concept, because the owner is not
recognised as such but as an equityholder, a provider of funds. So-called owners
are not seen as having the power to make decisions for the firm. The net assets
belong to the entity. However, net worth can be a meaningful concept. An
argument can be made that the entity needs to know the worth of its net assets for
its own purposes.

(d) The reason is that the entity is the focus of attention, and therefore creditors and
owners are seen simply as those who supplied the funds to the entity. Their
financial interest in the company is ‘equities’ — claims on the assets. Thus, they
are seen as equityholders. Their relationship with the company is a contractual
one.

(e) Paton and Littleton argue that the shareholders have a contractual residual claim
on the assets, and it is for this reason that income is placed in the retained earnings
account. Shareholders get the leftovers after the creditors have been paid, in the
event of liquidation of the company. The newer view of entity theory sees retained
earnings as the firm’s equity or investment in itself.

(f) Profit is stressed for two reasons:

 Profit is what equityholders are interested in, because it represents the results
of their investment in the company
 The firm is in business to make a profit — profit is essential to the firm’s
survival.

(g) Revenue is the inflow of assets (increase in total assets) due to the events
undertaken by the firm with regard to its output. Under the proprietary theory,
revenue is the increase in proprietorship. Expense is the decrease in assets or
increase of liabilities due to the consumption of assets and services by the firm to
generate current revenue. Under proprietary theory, expense is the decrease in
proprietorship.

For both the entity and proprietary theories, profit is the difference between
revenues and expenses. Entity theory, however, emphasises the left side of the
accounting equation (assets), whereas the proprietary theory concentrates on the
right side (proprietorship). Entity theory focuses on what the entity does, its
performance; whereas proprietary theory focuses on the effect on proprietorship.

For traditional entity theory, interest charges, dividends and income taxes should
be distributions of earnings. The theory considers these as payments to the
equityholders for the use of their funds. Of course, the government does not
provide funds as the others, but provides intangible services (funds?) such as
protection from foreign powers. The newer version of entity theory sees interest
charges, dividends and income taxes as payments to ‘outsiders’, and therefore
they are expenses.

3
 (h) Although conventional accounting theory subscribes to entity theory, the theory
has had little effect on actual practice. The reason is that the theory was
formulated in the 20th century, and many current practices were devised since the
time of the Italian city–states and are based on the proprietary theory. The
following show the effect of the entity theory on practice:
 The physical capital view is in consonance with the entity theory.
 Salaries to corporate employees who are also shareholders are expenses,
because the company is a separate, distinct entity from the holders.
 In consolidating financial statements, an entity theoretical approach can be
taken. Instead of concentrating on the proprietary interest of the parent (parent
company theory), entity theory sees the consolidation from the point of view of
the consolidated entity.
 The use of profit and cost centres for internal purposes is based on entity
theory. The centre is seen as an individual entity.

3. Liabilities are all ‘obligations’ under the Framework definition of liabilities. What
is an obligation, and why does the Framework rely heavily on it in the definition?

A liability is a present obligation to act or perform in a certain way. An obligation is a

duty; a responsibility or requirement. It may be legally enforceable in the courts or
simply ‘equitable’ or ‘constructive’. The Framework definition emphasises the future
sacrifice, but it should be remembered that a liability exists now — it is also a presently
existing requirement.

8.4 If a liability is a present obligation, does that mean that a legally enforceable claim
must exist before a liability exists? Explain. Conversely, if a legally enforceable
claim exists, does that mean that a liability must exist? Explain.

A liability need not be legally enforceable. According to the Framework for the
Preparation and Presentation of Financial Statements, it may be equitable or
constructive. Most liabilities are legal liabilities, but company policy of a ‘moral
obligation’ may give rise to a recordable liability as long as the intent is to transfer
assets or render a service to settle the obligation. Examples are Christmas bonuses that
may be accrued if not paid in December, or vacation pay. The past transaction or event
is not as clear for non-legal liabilities as for legal liabilities, and thus may be more
difficult to recognise. For such liabilities, the future sacrifices cannot be avoided
without significant penalty, such as a decrease in employee morale. Interpreting the
meaning of significant penalty is a matter of opinion.

A legally enforceable claim need not exist for an asset to exist according to the
Framework. Control is the main criterion, not ownership.

On the other hand, if a legally enforceable claim against the entity exists, it is clear that
there is a present obligation, and presumably a liability.

4
8.6 Hunter Ltd is attempting to bring its accounts in line with Australian accounting
standards and statements of accounting concepts. Advise the accountant of Hunter
Ltd whether a liability exists in each of the following cases and, if so, what the
liability is:
(a) The company is being sued for injuries sustained by an employee who
claimed that the workplace steps he fell down were unsafe. The outcome of
the lawsuit is highly uncertain.
(b) An order for raw materials has been placed with the firm’s regular supplier.
(c) There is a signed contract for the construction by Suzanna Ltd of a major
item of plant for Hunter Ltd.
(d) The firm has unsecured notes of $1 000 000 outstanding. Interest is payable
6-monthly in June and December. It is now August.
(e) At the end of the year, half of the firm’s employees have non-vested sick
leave owing.

(a) Contingent liabilities are not recorded, but are disclosed. A decision must be
made on whether these items are ‘straight’ liabilities or contingent liabilities. This
decision is based on two criteria: (1) it is probable that a liability has been
incurred; and (2) the amount can be estimated reliably.

In this case, there is no liability. According to the Framework for the Preparation
and Presentation of Financial Statements,, the event must make it ‘probable’ that
a liability has been incurred and the amount must be ‘estimable’. These two
conditions are not met.

(b) No liability. The pertinent event is not placing an order but receiving title to the
goods. When title passes, then a purchase has been made, and accounts payable is
recorded.

(c) Unclear. Until there is performance, there is nothing to record as no party has an
obligation under the contract until there is some performance under that contract.
On the other hand, if signing the contract has created that legal obligation, then a
liability and an equal asset should be recorded — the event is the signing of the
contract and the passing of some form of consideration that creates rights and
obligations under the contract.

(d) Interest payable for two months. Accrued interest is to be recorded. The event is
the passing of time; the company is using the money that was borrowed each day.

(e) No liability exists for the non-vested rights. The following four conditions can be
considered for the recording of an accrued liability for sick pay:
the sick pay is based on services already rendered
rights to sick pay are vested or ‘accumulated’ (earned but unused)
payment is probable
the amount can be reasonably estimated.

If sick pay benefits vest, an accrual should be made. If they ‘accumulate’

5
8.9 In your opinion, when should the following be recognised as assets or liabilities?
Explain whether, how and why, your answer deviates from Australian accounting
standards.
(a) Accounts payable
(b) Put options
(c) Call options
(d) Raw materials inventory
(e) Finance lease obligations
(f) Operating lease obligations
(g) Warranty commitments

(a) Accounts payable. A purchase has occurred on account; payment is probable.

Record a liability at the time of the transaction. Consistent with IAS 39.

(b) Put options (the holder has option but not the obligation to sell the underlying
item). A derivative financial instrument under IAS 139. The standard requires
recognition at fair value at date of transaction and remeasurement at subsequent
balance date, with increases and decreases in value to be recorded in the income
statement. Derivates are in the ‘fair value through profit and loss’ category of IAS
39.

(c) Call options (the holder has the right to buy the underlying item). As for (b).

(d) Raw materials inventory. If a perpetual system is used, a purchase (expense) has
occurred and the amount of asset remaining at the end of the period is recorded in
a stocktake. If a periodic system is used, the amount of inventory that the firm has
title to is recorded as an asset at the date of purchase of the raw materials.

(e) Finance lease obligations. According to AASB 117, a finance lease obligation

occurs when the lease transfers substantially all the risks and rewards incidental
to ownership of an asset. The standard mandates that at the commencement of the
lease term, lessees shall recognise finance leases as assets and liabilities in their
balance sheets at amounts equal to the fair value of the leased property or, if
lower, the present value of the minimum lease payments, each determined at the
inception of the lease. Lessors shall recognise assets held under a finance lease in
their balance sheets and present them as a receivable at an amount equal to the net
investment in the lease.

(f) Operating lease obligations. AASB 117 specifies that in the books of the lessee,
lease payments under an operating lease shall be recognised as an expense on a
straight-line basis over the lease term unless another systematic basis is more
representative of the time pattern of the user’s benefit. For lessors, lease income
from operating leases shall be recognised in income on a straight-line basis over
the lease term, unless another systematic basis is more representative of the time
pattern in which use benefit derived from the leased asset is diminished.

(g) Warranty commitments. A liability arises with the sale of the product and the
existence of warranty contract. At this stage, the amount can be reasonably
estimated. The contract means there is a present obligation to an external party.

6
 The amount to be claimed can be reasonably estimated based on the company’s
past experience.

Explain the concept of capital maintenance, and how it can apply to different concepts
of capital.

The main source of income for an entity is an increase in the wealth of a firm resulting
from operations for the period. This can be described as the maximum amount that can
be distributed to owners and still leave the firm as well off at the end of the period as at
the beginning. This maximum amount that can be distributed is income; the amount
that needs to be retained to leave the firm as well off at the end of the period as at the
beginning of the period is capital.

Under the concept of capital maintenance, then, income is only that amount that can be
distributed without impairing the capital of the firm. So, capital cannot be distributed to
owners as dividends, only income.

Current cost accounting aims to ensure the firm’s physical/operating capital base is not
eroded during periods of inflation, as the otherwise inflated profits reported can result
in increased dividends that actually result in reducing the ‘real’ capital of the firm.

Under a general price level accounting system (GPLA or CPP), income is recognised
only after the purchasing power of the start-of-period owners’ equity has been
maintained.

Under CoCoA, the concept of capital is ‘adaptive capacity’ so income is not recognised
until the firm earns enough to maintain its operating adaptive capacity, as reflected in
the net realisable value of its assets, less liabilities.

7
4. If a liability is a present obligation, does that mean that a legally enforceable claim
must exist before a liability exists? Explain. Conversely, if a legally enforceable
claim exists, does that mean that a liability must exist? Explain.

A liability need not be legally enforceable. According to the Framework for the
Preparation and Presentation of Financial Statements, it may be equitable or
constructive. Most liabilities are legal liabilities, but company policy of a ‘moral
obligation’ may give rise to a recordable liability as long as the intent is to transfer
assets or render a service to settle the obligation. Examples are Christmas bonuses that
may be accrued if not paid in December, or vacation pay. The past transaction or event
is not as clear for non-legal liabilities as for legal liabilities, and thus may be more
difficult to recognise. For such liabilities, the future sacrifices cannot be avoided
without significant penalty, such as a decrease in employee morale. Interpreting the
meaning of significant penalty is a matter of opinion.

A legally enforceable claim need not exist for an asset to exist according to the
Framework. Control is the main criterion, not ownership.

On the other hand, if a legally enforceable claim against the entity exists, it is clear that
there is a present obligation, and presumably a liability.