What Is the Entity Theory?

The entity theory is a legal theory and accounting concept that all of the business activity conducted by any corporation or limited liability business is separate from that of its owners. The entity theory has two aspects. In accounting, it means that business and personal accounts, transactions, assets, and liabilities should be accounted for under separate and district entities independently of the owners' 澳洲幸运5开奖号码历史查询:personal finances. In business law, it means that, under the premise of 澳洲幸运5开奖号码历史查询:limited liability, the owners of a business that is structur🧔ed as a separate entity should not be held personally liable for the liabilities in✤curred by the business.

Despite some criticisms, due in large part to its fictitious nature and the agency problems it creates in practice, the entity theory has been invaluable to 澳洲幸运5开奖号码历史查询:limited liability company (LLC) accountin🧔g practices and the status of corporations today as juridical persons.

Understanding the Entity Theory

Under the entity theory, an individual or group of people working together as a business firm is treated as a separate legal and accounting entity, essꦍentially creating a fictional person. Anyone who does business with that individual or group is considered in the legal and accounting senses to be doing business with the firm rather than the people with whom they are actually dealing.

This allows both 1) the collective accounting for transactions, and 2) the legal ownership and responsibility for assets and liabilities to be recorded and adjudicated separately from any other activities that the members of the firm engage in. Grouping the accounting of transactions together under separate entities means that profits (or losses) and the net value of relevant assets can be calculated more easily in order to facilitate rationa൲l economic decision-making.

Making business firms fictional persons in the eyes of the law means that firms can own assets and property, issue debt (borrow money), ꦑenter into contracts, and so o🐓n. Firms can also be sued, without also suing the ownership and management personally.

Under the entity theory, the 澳洲幸运5开奖号码历史查询:accounting equation𓆏 for a business balance sheet depicts the firm as an entity (the sum total of its assets) on one side of the equation, against two separate entities, the stockꦐholders (who hold the firm's equity) and the creditor (who hold the firm's liabilities or debts):

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

This can be contrasted to the equation for the balance sheet equation of a sole proprietorship or non-limited liability company or the net worth of an individual, which depicts the value of the business (or individual) as the difference between the assets t🐬hat they own and the debts that they are liable for, all as a single legal and accounting entity.

By insulating owners of a business from full liability for the actions of business, the application of the entity theory facilitates the concentration of productive assets under the control of managers ꦉand employees of a business who usually have more specialized knowledge and skills as to how to apply those assets profitably.

Limiting owner's liability is a way to induce them to entrust control over their assets to managers who can use them more productively than the owners themselves can, increasing opportunities for cooperative business activities that produce value for all the individuals involved.

Criticisms of the Entity Theory

Though the basic concept of th𒅌e entity theory has been circulating since at least the 19th century and is the prevailing manner in which business is conducted and accounted for all over the world, it is not always intuitively understood by many people. This is mainly due to the somewhat obvious problem that it requires that people believe, or at least pretend to believe, in i♉maginary entities that exist only on paper in accounting statements and legal documents.

In reality, a company is not itself an independent entity, but a collective pretense of the owners, managers, employees, and other 澳洲幸运5开奖号码历史查询:stakeholders involved in business transactions with them. However, entity theory requires that real people, at least in their business and legal dealings, act as if they believe that imaginary people really e🔴xist. This legal and accounting pretense is designed to help keep track of and protect profits that the business generates and encourage productive investment, though it may seem almost like magic or perhaps voluntary insanity.

This profit is invariably linked to the owners' wallets, but the application of entity theory in accounting and law shields those wallets from the full costs and risks that the business also generates. The second criticism of entity theory is that it can create and exacerbate 澳洲幸运5开奖号码历史查询:agency problems by separating ownership—claims on profits—from control over the actual busines♏s activities that generate those profits.

Owners who are insulated, in an accounting sense but especially in a legal sense, from full liability for the costs and risks that their business creates simply have less incentive to care if a firm incurs debts it cannot pay or imposes costs and risks on outsiders and bystanders (which economists call 澳洲幸运5开奖号码历史查询:externalities).🅷 Employees and managers likewise have less incentive toღ care if their actions harm the interests of the owners or third parties when they know that the owners' risk is limited and that their own risk of loss is similarly limited to the risk of losing their jobs.