The nature of equity

Of the five financial statement elements, equity is the most mercurial. In part, because it’s total amount is measured as the total of recognised assets less the total of recognised liabilities, expressed in this form of the accounting equation.

Assets – Liabilities = Equity (net assets)

Measuring total equity as a residual is what makes balance sheets balance. They balance because equity includes retained earnings — a residual amount determined by the recognition criteria that are applied to assets and liabilities.

Describing how equity is measured, however, says nothing of its inherent nature. So, let’s start with a quick one liner:

Equity is not valuable. It is an obligation.

Equity is not described this way in the conceptual frameworks of FASB and IFRS. Their definitions, however, are problematic because they use a viewpoint inconsistent with that used to define assets and liabilities.

The definitions differ in some details but both FASB and IFRS describe assets as rights of the entity. Likewise, liabilities are defined as obligations of the entity. The standing point is clear. These elements are defined as rights and obligations of the reporting entity.

When it comes to equity, however, the standing point moves. FASB defines equity as the residual interest of the owners in the net assets of the entity ^[1], while the IFRS defines equity as claims on the residual interest in the assets of the entity after deducting all its liabilities ^[2]. Equity is defined not from the viewpoint of the entity, but as the aggregate claim of all investors.

This is a deliberate attempt to maintain a binary distinction between equity and liabilities, but it is not helpful to students struggling to understand the nature of equity from the entity’s perspective.

How to explain equity to students

Some students, even those with prior accounting knowledge, come to class with a clear notion that equity is valuable because it’s “the money invested by shareholders”. It isn’t — cash is the money shareholders invest, and cash is an asset. This notion of equity collapses accounting duality in the same way that cash sales does, which we discuss in The nature of income.

Early in our elementary accounting courses, we show students this picture and ask them what My Supermarket Limited is worth.

The answer, as always, depends on the point of view. Some students suggest £50,000 because that’s the value of its assets, but the question asks the entity’s worth, not the assets.

The most common answer is £20,000 because that’s the value of net assets and equity. This assumes, however, that the question is about the worth of the business from the shareholders’ point of view. Prompt students to consider the lender’s viewpoint and are more likely to suggest that the answer is £30,000, the recoverable loan amount.

The purest answer is that, from the entity’s point of view, it is worth nothing. The value of assets is always equivalent to the total of liability and equity claims. This, after all, is what the accounting equation tells us.

In the article on teaching liabilities, the point was made that my liability is your asset. If I have an obligation to you, then you have rights you can enforce against me. My promise to repay you the money that you lent me is mirrored by your right to collect that money from me.

Admittedly, shareholders do not have the same set of rights as lenders and creditors, but they do have identifiable claims. Quoting FASB again, “Owners invest in a business enterprise with the expectation of obtaining a return on their investment…” ^[4].

It is rational and consistent, therefore, to define equity as the entity’s obligation to meet those expectations. It’s all about point of view. The owner has rights and therefore the entity has an obligation to the owner.

Accounting regulators appear not to have noticed their inconsistency of approach and can become a little cranky if you point it out, but hold your ground — equity has different characteristics to liabilities, but, from the entity’s point of view, it’s an obligation and is not valuable.

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References

1. FASB (1985) Statement of Financial Accounting Concepts No. 6, paragraphs 49 and 60

2. IFRS (2018) Conceptual Framework, paragraph 4.63

3. Wealthvox (2020) Colour Accounting Learning System

4. FASB (1985) Statement of Financial Accounting Concepts No. 6, paragraph 51

Resources

PowerPoint slide (180KB) of the illustration above. Free to use in teaching.