Residual Equity Theory

Residual equity theory assumes common shareholders to be the real owners of a business. Their residual equity, or net income, is calculated by subtracting the claims of bondholders and preferred shareholders from a company's assets.

Common stock = Assets - Liabilities - Preferred Stock

Residual equity theory was developed by Professor George Staubus at the University of California, Berkeley's Haas School of Business. An advocate for the continued improvement of the standards and practices of financial reporting, he argued its primary objective should be to provide information that is useful in making investment decisions.

Staubus' decision-usefulness theory was the first to link cash flows to the measurement of assets and liabilities, and their importance in investment decisions. It would eventually become the basis for generally accepted accounting principles and the Financial Accounting Standards Board's conceptual framework.

Because common shareholders are the last in line to be repaid if the company goes bust, he argued they should be given sufficient information about corporate finances and performance to make sound investment decisions. This led to the earnings per share calculation that applies only to common stockholders.

Residual equity theory is an alternative to the proprietary theory of accounting, which calculates the owner's net worth as assets minus liabilities. Proprietary theory, which treats the owner of an enterprise as an extension of the firm itself, is most applicable to partnerships and sole proprietorships.

Other equity theories include the entity theory, in which a firm is treated as a separate entity from owners and creditors, and its 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.