Residual Interest
Equity is defined in IAS as “the residual interest in the assets of the enterprise after deducting all its liabilities.” U.S. GAAP provides a similar definition: “Equity or net assets is the residual interest in the assets of an entity that remain after deducting its liabilities.” A consideration of equity as what remains, a residual interest, illustrates the effect and importance of some accounting assumptions and conventions. The notion of a residual is literally meaningful only in the event of corporate liquidation, when the firm would cash out its assets and distribute them to satisfy all claims. The external claimholders would be satisfied first, followed by the preferred stockholders. Any remaining assets would then be distributed to common shareholders. The event of liquidation, however, violates the going concern assumption under which financial statements are normally prepared.
Since many assets and liabilities are not measured at market value under U.S. GAAP or IAS, owners’ equity is similarly imprecisely measured on the balance sheet. The result is that this statement cannot currently be used for determining the liquidation value of a company. Accounting standard setters around the world, however, have been moving toward a fair value model, where many more assets and liabilities are reported in the balance sheet at fair value than have been so reported in the past.
In a healthy firm, absent liquidation, the notion of a residual claim is less meaningful. The stockholder who wants to cash in her interest will do so in the equity markets by selling stock to another party. This sale will occur at current market value for the stock, without necessitating a simultaneous valuation of the underlying assets of the firm. The value (market value) reflects the market’s expectation of the future cash flows to be received from the investment in the company’s shares. Thus, the historical cost amounts on the balance sheet (book value) offer little in the way of precise guidance to the stockholder who wants to liquidate her holdings.
For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
