Rethinking the Concept of Equity in Accounting: Origin and Attribution of Business Profit

In this paper I reconsider the concept of equity in corporate accounting from the perspective of the origin and attribution of business profit. In both Financial Accounting Standards Board’s (FASB’s) and International Accounting Standards Board’s (IASB’s) Conceptual Frameworks, shareholders’ equity is synonymous with a firm’s net assets. However, it is not the sole definition of equity. We may regard equity as the interest in the corporate capital itself. From this viewpoint, shareholders’ equity consists of retained earnings attributable to shareholders’ as well as invested capital provided by them. We should note that, under the current corporate accounting system, shareholders are assumed to be the sole residual claimants. However, the existence of implicit contracts in corporate activities implies other residual claimants in addition to shareholders. If shareholders are not the sole residual claimants, it is necessary to revisit the proprietary theory under which equity is identical to shareholders’ equity. In this paper I reconsider the significance of the entity theory, which emphasizes an entity as an organization comprising various stakeholders and attributes business profit above shareholders’ expectations to an entity itself. The ownership interest cannot generate the excess profit by itself. Without firm-specific investments by employees and/or entrepreneurial activities by managers, the excess profit would never emerge. We should critically examine the foundation of the current corporate accounting in order to design a more equitable and efficient corporate accounting in which business profit is attributable not only to shareholders but also to other stakeholders who contribute to its generation.