Residual Equity Theory

What Is Residual Equity Theory?

Residual equity theory assumes common shareholders to be the real owners of a business. It follows that accountants and corporate managers must also adopt the perspective of shareholders.

Under this theory, preferred stock is a liability for common shareholders rather than part of the firm's 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.

How Residual Common Equity Works

In residual equity theory, the equity value of a firm is calculated by subtracting the claims of debtholders and preferred shareholders from a company's assets. Preferred stockholders have a higher claim on distributions (e.g., dividends) than common stockholders and behave somewhat like a hybrid between common equity and a corporate bond in that it pays a steady dividend. Preferred stockholders usually have no or limited, voting rights in corporate governance.

Residual Common Equity = Assets - Liabilities - Preferred Stock

Residual equity is thus identical in value to the firm's common stock.

Common shareholders are the last in line to be repaid if a company files for bankruptcy, so the theory asserts that equity should be calculated from their point of view. The theory argues that they should receive sufficient information about corporate finances and performance to make sound investment decisions. This leads to the earnings-per-share (EPS) calculation that applies only to common stockholders.

The Development of Residual Equity Theory

George Staubus, a financial accounting researcher, 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).

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.