DEFINITION of 'Entity Theory'

The entity theory is a basic assumption that all economic activity conducted by a business is separate from that of its owners. The 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 this theory, the owners aren't personally responsible for the company's loans and liabilities.

BREAKING DOWN 'Entity Theory'

In terms of business liability, 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. The entity theory is integral to all aspects of commerce.

Accounting and the Entity Theory

The entity theory is a fundamental aspect of modern accounting. It's based on a simple equation:

Assets = Liabilities + Stockholders' Equity

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.

Criticism of the 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.

Bottom Line

Despite the fact that the theory is not excessively popular, due in large part to the lack of realism of the relationship in practice, entity theory has been invaluable to limited liability company accounting practices.

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