What Is Entity Theory?

The entity theory is a basic theoretical assumption that all of the economic activity conducted by a business is separate from that of its owners. Entity theory is based on the idea that all of a company's activities can and will be accounted for independently of the owners' activities under the premise of limited liability, or the separation of ownership from control.

Under entity theory, the owners are not personally responsible for the company's loans and liabilities and so creditors cannot go after owners' personal assets.

Despite some criticisms, due in large part to the lack of realism of the relationship in practice, entity theory has been invaluable to limited liability company (LLC) accounting practices and the status of corporations today as juridical persons.

The Basics of Entity Theory

In terms of ownership versus control, limited liability for owners in certain businesses is essential for commerce. To maintain a system that separates owners from company liability, the entity theory establishes a baseline that makes it possible to separate the business finances from that of the owners. The separation of personal and professional business activities is a consistent and significant aspect of commerce around the world. Entity theory is integral to all aspects of commerce.

Entity theory is a fundamental aspect of modern accounting. It's based on the simple balance sheet accounting equation:

Assets=Liabilities+Stockholders’ Equitywhere:Liabilities=All current and long-term debts and obligationsStockholders’ Equity=Assets available to shareholders after all liabilities\begin{aligned} &\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}\\ &\textbf{where:}\\ &\text{Liabilities} = \text{All current and long-term debts and obligations}\\ &\text{Stockholders' Equity} = \text{Assets available to shareholders after all liabilities}\\ \end{aligned}Assets=Liabilities+Stockholders’ Equitywhere:Liabilities=All current and long-term debts and obligationsStockholders’ Equity=Assets available to shareholders after all liabilities

Under the entity theory, liabilities are equities with separate legal standing and rights within the business. In relation to accounting, the entity theory keeps obligations, assets, revenues, any expenses, and all other financial aspects of a company separate from the personal finances and financial activities of the company's owners. Thus, the identity of the company and the identity of the company's owners and managers are separate.

This means that corporations are juridical persons in the eyes of the law – the firm can own assets, property, issue debt (borrow money), enter into contracts, an so on. Firms can also be sued, while the ownership and management remain in the clear personally.

Criticisms of Entity Theory

Though the basic concept of the entity theory has been circulating since the 19th century, it has failed to gain an overwhelming following. This is partially due to the main and somewhat obvious criticism that has been attached to the theory.

Ultimately, a company is not itself an independent entity, but a tool or extension of the owners (and/or managers) that is designed to generate a profit. This profit is invariably linked to the owners' wallets. The owners are similarly tied to the company in that they are likely to be significant stakeholders in the firm.

Thus, for every penny of investment the owners pour into the company, they expect a return. Investment in the company does not only involve capital but, typically, involves physical and intellectual capital – or the time, sweat and mental facilities that the owners have invested in the company.