The purpose of this article is to discuss the three theories business combination theories: proprietary theory, parent company theory, and entity theory. Included will be a description of each theory.
The proprietary theory is a theory that “views the firm as an extension of its owners” (Baker et al.). Under this theory, for accounting purposes the entity does not exist separately from its owners. Therefore, financial statements are prepared for the benefit of the owners and from the owners’ perspective. The assets of the company are viewed as assets of the controlling shareholders and the liabilities of the company are viewed as liabilities of the controlling shareholders. In addition, “revenue of the firm is viewed as increasing the wealth of the owners, while expenses decrease the wealth of the owners” (Baker et al.). The proprietary theory causes increased profits in each individual company instead of the entire group of companies as a whole. “The parent company consolidates only its proportionate share of the assets and liabilities of the subsidiary” (Baker et al.), and the proportionate share of non-controlling shareholders’ assets are omitted from the consolidated financial statements.
Parent Company Theory
The parent company theory is a theory under which consolidated financial statements are prepared for the benefit of and from the viewpoint of the parent company stockholders. “The parent company theory recognizes that although the parent does not have direct ownership of the assets or direct responsibility for the liabilities of the subsidiary, it has the ability to exercise effective control over all of the subsidiary’s assets and liabilities, not simply a proportionate share” (Baker et al.). Net income is not consolidated under the parent company theory.
The entity theory is “a theory under which consolidated financial statements are prepared from the view of the total business entity” (Beams et al.). The legal entity is considered to have a separate existence from the owners for accounting purposes. Consolidated statements are “intended for all parties having an interest in the entity” (Beams et al., 2006, p. 373). Controlling and non-controlling shareholders are considered separate and distinct, with each having an ownership interest in the consolidated entity. The controlling shareholders, non-controlling shareholders, and consolidated entity are considered equal, with no preference or emphasis given to any of these groups. Under this theory, all assets, liabilities, equity, and profit or loss are combined into one entity regardless of the separate controlling and non-controlling interests involved, and consolidated net income is combined and allocated between the ownership groups.
Baker, R. E., Lembke, V. C., & King, T. E. “Advanced Financial Accounting Chapter 3.” McGraw-Hill website. URL: http://highered.mcgraw-hill.com/sites/0072866322/student_view0/chapter3/powerpoint_presentations.html
Beams, F. A., Anthony, J. H., Clement, R. P. & Lowensohn, S. H. “Advanced Accounting.” (9th ed.) Upper Saddle River, NJ: Pearson Prentice Hall.