What Is Residual Equity Theory?

Residual equity theory assumes common shareholders to be the real owners of a business. It follows that accountants must adopt their perspective. To common shareholders, preferred stock is a liability rather than part of equity.

After subtracting preferred shares, only common shares remain as the residual equity. This is the basis of residual equity theory, and common shareholders can be thought of as residual investors.

The proprietary theory of accounting is the most popular alternative to residual equity theory; introductory accounting classes generally emphasize proprietary theory and calculates equity as assets minus liabilities.

How Residual Common Equity Works

In residual equity theory, residual equity is calculated by subtracting the claims of debtholders and preferred shareholders from a company's assets.

  • Residual Common Equity = Assets - Liabilities - Preferred Stock

Residual equity is also identical with common stock.

The Development of Residual Equity Theory

Professor George Staubus developed residual equity theory at the University of California, Berkeley. Staubus was an advocate for the continued improvement of the standards and practices of financial reporting. He argued that the primary objective of financial reporting should be to provide information that is useful in making investment decisions.

Staubus made substantial contributions to decision-usefulness theory, which was the first to link cash flows to the measurement of assets and liabilities. This approach emphasizes information that is important for making investment decisions. Decision-usefulness theory was eventually incorporated into generally accepted accounting principles (GAAP) and the conceptual framework of the Financial Accounting Standards Board (FASB).

Common shareholders are the last in line to be repaid if a company files for bankruptcy, so Staubus believed that we should calculate equity from their point of view. He argued they should receive sufficient information about corporate finances and performance to make sound investment decisions. This led to the earnings-per-share calculation that applies only to common stockholders.

Key Takeaways

  • Residual equity theory assumes common shareholders to be the real owners of a business.
  • Residual equity is also identical with common stock.
  • In residual equity theory, residual equity is calculated by subtracting the claims of debtholders and preferred shareholders from a company's assets.
  • Professor George Staubus developed residual equity theory at the University of California, Berkeley.

Special Considerations: Alternative Theories

The proprietary theory of accounting is the most popular alternative to residual equity theory. Introductory accounting classes generally emphasize proprietary theory, and it calculates equity as assets minus liabilities. Proprietary theory works best for sole proprietorships and partnerships, and it is easier to understand. However, residual equity theory can present a more accurate picture when investing in publicly traded companies.

Other equity theories include the entity theory, in which a firm is treated as a separate entity from owners and creditors. In the entity theory, a firm's income is its property until distributed to shareholders. Enterprise theory goes further and considers the interests of stakeholders such as employees, customers, government agencies, and society.