Entity theory

From CEOpedia | Management online

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 p. 9-11):

∑ assets = ∑ equities + ∑ liabilities (Hendriksen and Van Breda 1992, p. 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 p. 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 p. 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.

Examples of Entity theory applications

  • Limited Liability Company (LLC): A limited liability company is a type of business structure that provides limited liability protection to its owners and shareholders. This means that the company's owners and shareholders are not personally liable for the company's debts or liabilities. This type of business structure is popular in the United States, as it allows owners to limit their personal liability while still enjoying the benefits of operating a business.
  • Corporation: A corporation is a type of business entity that provides limited liability protection to its owners and shareholders. Similar to an LLC, the owners and shareholders of a corporation are not personally liable for the company's debts and liabilities, and are thus protected from financial losses. Corporations are typically used for larger businesses, as they offer more flexibility in terms of ownership and operations.
  • Sole Proprietorship: A sole proprietorship is a type of business structure in which one individual owns and operates the business. This type of business does not provide any liability protection to the owner and thus, the owner is personally liable for any debts or liabilities that the business may incur. This type of business structure is the simplest and least expensive to form, but it does not offer any protection to the owner.

Advantages of Entity theory

One of the main advantages of Entity Theory is the separation of personal finances from the finances of the business. This means that owners and shareholders are not held personally liable for any debts or liabilities of the company. This provides a great deal of financial security for owners and shareholders, as they are not at risk of losing personal assets. The other advantages of Entity Theory include:

  • Limited Liability: This theory limits the amount of liability that owners and shareholders are responsible for. This means that they will not be liable for any debts or obligations that the company incurs.
  • Tax Benefits: The Entity Theory also provides tax benefits to the owners and shareholders, as the company is treated as a separate entity for tax purposes. This means that the company will pay its own taxes, rather than the owners and shareholders paying taxes on the company’s profits.
  • Easier Financing: Entity Theory makes it easier for the company to obtain financing, as the owners and shareholders are not liable for any of the company’s debts. This makes it easier for the company to secure financing from banks or other lenders.

Limitations of Entity theory

The Entity theory has several limitations:

  • It does not consider the fact that company owners may be involved in the daily operations of the business and may influence decisions. This means that if the owners make a bad decision, they could be held liable for the outcome and be personally responsible for the company’s losses.
  • Entity theory assumes that the company has an independent existence, however, in reality a company is often dependent on the actions of its owners.
  • The theory assumes that owners cannot be held personally responsible for the company’s debts and obligations, however, this may not be true in certain cases.
  • The theory does not apply in cases where there is fraud or illegal activity, as the owners can be held personally liable for these actions.
  • It also does not consider the fact that shareholders may be held liable for a company’s actions if they fail to exercise their fiduciary duties.

Other approaches related to Entity theory

One of the other approaches related to Entity Theory is the Limited Liability Theory, which states that shareholders are not personally liable for the debts and obligations of the company. *Piercing the Corporate Veil is another approach, which allows creditors to hold shareholders liable for the debts of the company when certain conditions are met, such as fraud or when there is not a clear distinction between the company and its owners.*The Corporate Veil Doctrine is also related to Entity Theory and states that the company's liabilities should be distinct from the liabilities of its shareholders.*The Corporate Opportunity Doctrine is a theory that states that directors and officers of a company are obligated to act in the best interests of the company, and not to take advantage of any potential opportunities that may be available to them.

In summary, Entity Theory is the legal principle that separates a company’s finances from the personal finances of its owners and shareholders. Other related approaches include Limited Liability Theory, Piercing the Corporate Veil, Corporate Veil Doctrine and Corporate Opportunity Doctrine. These theories protect owners and shareholders from being held liable for the debts and obligations of the company.


Entity theory — recommended articles
Shareholder loan — Spendthrift clause — Working interests — Ownership interest — Fixed and floating charge — Dividend irrelevance theory — Nominee shareholder — Special power of attorney — Dissenters right

References

Author: Aneta Walczyk

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