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Residual Equity Theory
The residual equity theory thrives on the belief that the common shareholders of a company are the real owners of the business. Common shareholders are holders of common stock in a company and the residual theory assumes they are the real business owners.
Common stock = Assets – Liabilities – Preferred stock
To calculate residual equity, the claims of the bondholders and preferred shareholders will be subtracted from the company’s assets.
A Little More on What is Residual Equity Theory
Usually, the common shareholders of a company are the last to be paid any claims in the event of the failure or collapse of a business, this suggests that they are the stronghold of a business and are the last line to be repaid. The residual equity theory assumes that common shareholders are the real owners of business because of the position they hold.
George Staubus, a Professor at the University of California, developed the residual equity theory. According to Staubus, the common shareholders of a company should have access to sufficient information about the company, including its finance so that they can make the best investment choices. In order to improve the standards of financial reporting of a company in compliance with GAAP, adequate information must be provided to all common shareholders.
Residual Equity Theory vs. Proprietary Theory
The Residual equity theory and the Proprietary Theory are used interchangeably. The latter is an accounting method that calculates the owner’s net worth by deducting the total liabilities from that total assets. The proprietary theory is closely associated with sole proprietorships and partnerships as it considers the owner of a business or enterprise as an extension of the business. The residual equity theory, on the other hand, considers the common shareholders of a company as the real owners of the business.
Other equity theories exist, such as the entity theory which considers a company distinct from its owners or creditors.