What is entity theory?
Entity theory is a legal theory and accounting concept that all business activity carried out by a company or limited liability company is separate from that of its owners. Entity theory has two aspects. In accounting, this means that business and personal accounts, transactions, assets and liabilities should be accounted for under separate and district entities regardless of the personal finances of the owners. In business law, this means that, under the principle of limited liability, the owners of a business structured as a separate entity should not be held personally liable for the liabilities incurred by the business.
Despite some criticism, due in large part to its fictitious nature and the agency problems it creates in practice, entity theory has been invaluable to the accounting practices of Limited Liability Companies (LLCs) and the statute. companies today as legal persons.
Key points to remember
- Entity theory is the legal and accounting doctrine that treats business enterprises as separate entities from their owners and other stakeholders.
- Entity theory allows the calculation of profits and losses among a set of related transactions and the formation of corporations and limited liability companies.
- Entity theory can be criticized for its inherent detachment from reality and its possible contribution to agency problems.
Understanding Entity Theory
According to entity theory, an individual or group of people working together as a business enterprise is treated as a separate legal and accounting entity, essentially creating a fictitious person. Anyone who does business with this person or group is considered, in a legal and accounting sense, to do business with the company rather than with the people with whom it actually deals.
This allows both 1) collective accounting of transactions, and 2) legal ownership and liability for assets and liabilities to be recorded and dealt with separately from any other activity in which members of the business engage. entities means that the profits (or losses) and net worth of the relevant assets can be calculated more easily in order to facilitate rational economic decision-making.
Making companies fictitious people in the eyes of the law means that companies can own assets and property, issue debts (borrow money), enter into contracts, etc. Businesses can also be sued, without also personally suing ownership and management.
According to entity theory, the accounting equation of a corporate balance sheet describes the business as one entity (the total sum of its assets) on one side of the equation, relative to two separate entities, the shareholders (who hold the equity of the company) and the creditor (who holds the liabilities or debts of the company):
Assets=Liabilities+Equityor:Liabilities=All current and long termdebts and obligationsEquity=Assets available forshareholders after all liabilities
This can be compared to the equation of the balance sheet equation of a sole proprietorship or an unlimited liability company or the net worth of an individual, which describes the value of the company (or l ‘individual) as the difference between the assets they own and the debts for which they are responsible, all as a single legal and accounting entity.
By isolating the owners of a company from all responsibility for the actions of the company, the application of entity theory facilitates the concentration of productive assets under the control of the managers and employees of a company who generally have more specialized knowledge and skills on how to apply these assets profitably.
Limiting the liability of owners is a way to induce them to hand over control of their assets to managers who can use them more productively than the owners themselves, thus increasing the opportunities for cooperative business activities that produce value. for all individuals involved.
Criticisms of Entity Theory
Although the basic concept of entity theory has been circulating since at least the 19th century and is the dominant way in which business is conducted and accounted for around the world, it is not always intuitively understood by many people. This is mainly due to the somewhat obvious problem of people having to believe, or at least pretend to believe, in imaginary entities that only exist on paper in accounting statements and legal documents.
In reality, a company is not itself an independent entity, but a collective semblance of owners, managers, employees and other stakeholders involved in business transactions with them. However, entity theory requires that real people, at least in their business and legal relationships, act as if they believe that imaginary people actually exist. This legal and accounting pretext is designed to help track and protect the profits generated by the business and encourage productive investment, even though it may seem almost magical or perhaps willful folly.
This profit is invariably tied to the owners’ portfolios, but the application of entity theory in accounting and law protects these portfolios from all of the costs and risks that the business also generates. The second criticism of entity theory is that it can create and exacerbate agency problems by separating ownership (rights to profits) from control over the actual business activities that generate those profits.
Owners who are isolated, in an accounting sense but more importantly in a legal sense, of full responsibility for the costs and risks that their business creates simply have less incentive to worry if a business incurs debt that it cannot. pay or impose costs and risks on third parties and bystanders (which economists call externalities). Employees and managers are also less likely to be concerned if their actions harm the interests of owners or third parties when they know that owners’ risk is limited and their own risk of loss is also limited to the risk of losing their job. .