Entity theory assumes that economic activity performed by a business is separate from individual opinions of the owners. Therefore, owners are not personally responsible for the company's problems, e.g. liabilities. Individual entity is responsible for its own liabilities. In other worlds the corporate's finances are separate from private finances of company owners. The assumptions of this theory protects owners and shareholders from paying debts or loans of the enterprise. Undisputed adventage of this is eliminating the risk of losing any personal properties.
There is no doubts that entity theory made certain constitutional rights applicable to every corporations. The entity theory is a fundamental assumption in today's business around the world. The company is separate from personal finances of the owners, so in case of company problems, owners are responsible only to the level of the money invested in that company. But they cannot be asked to pay debts from their own pocket.
Entity theory in accounting
The entity theory represents a concept of corporation as an autonomous and distinct entity. From accounting point of view entity theory definitely separates the accounts of the enterprise and the accounts of the owners. In order to follow this theory, accounting requires the use an individual accounting records for the corporation and entirely exclude the liabilities and assets of the owners or any other entities. Following concept assures visibility of accounting ledgers particular entity. Under the entity theory all transations made by specific legal unit are analysed as to their impact on this exact entity. The profit and loss acocunt is intended to calculate revenue and analyse the corporate's results in respect of the period. According to entity theory, financial position of company is mesured by equotion below (C. van Mourik, 2010 s.9-11):
∑ assets = ∑ equities + ∑ liabilities (Hendriksen and Van Breda 1992, s.771)
Assets shall be construed as resources owned by a company. Equities represent sources of the assets and reflect the difference between assets and liabilities (C. van Mourik, 2010 s.9-11). Entity theory puts emphasis on determining the revenue, as they must be accountable to the equity holder. With accordance to this theory income, assets and expenses of corporation are accounted for independently from owners. However, income is usually distributed as a dividends.
Criticism of entity theory
Entity theory posits that enterprise is an individual legal entity capable sue and be sued in its own name. Following assumtion contrasted with general business co-operation and partnerships where tradicionally the partnership was viewed as nothing more than an aggregation of the individual owners (S. J. Padfield 2013 s. 837). To this day many people have that poit of view in subconscious. It is caused by the fact that in real world owners are connected with the company, and their opinions effect on performance of the company. Therefore, some ask why loaners of the company cannot get back their money from owners in case of company bankruptcy. The owners expect return from money invested in company, so why shouldn't they take also the risk of loss? This leads to change of the legislation in some countries, where only in some special cases it is allowed to claim money also from owners of limited liability company.
- A. Huyue Zhang (2012) The Single Entity Theory: An Antitrust Time-Bomb for Chinese StateOwned Enterprises? - Journal of Competition Law and Economics, Volume 8, Issue 4, 805-830;The University of Hong Kong - Faculty of Law; King's College London
- C. van Mourik, (2010) The Open University's repository of research publications and other research outputs ; Equity theories and financial reporting: past, present and future - 22nd Annual Conference on Accounting, Business & Financial History, 6-7 Sep 2010, Cardiff.
- L. E. Mitchell (2006) The Relevance of Corporate Theory to Corporate and Economic Development: Comment on The Transplantation of the Legal Discourse on Corporate Personality Theories - Washington and Lee Law Review; Volume 63 | Issue 4, Article 9
- M. J. Phillips (1994) Reappraising the real entity theory of the corporation. Florida State University Law Review, Volume 21 | Issue 4, Article 1
- S. J. Padfield (2013) The silent role of corporate theory in the supreme court's campaign finance cases; Journal of constitutional law Vol. 15:3
- Y. Biondi & A. Canziani & T. Kirat (2007) The Firm as an Entity: Implications for Economics, Accounting and the Law; Routledge Taylor & Francis Group London and New York
Author: Aneta Walczyk