Entity Theory

What is Entity Theory?

Entity theory is a concept that advocates for the separation of business transactions and transactions of its owners. The theory states that assets of the owners should not be mixed with the business, as owners cannot be personally liable for the debts of the business. The entity theory enables one to accurately determine the financial position of the business by distinguishing between personal from business assets and liabilities.

Understanding the Entity Theory

The entity theory is largely associated with the limited liability concept, which applies to corporations and limited liability companies (LLCs) as opposed to a sole proprietorship structure. It states that owners have a separate identity from companies and that they are not personally liable to business creditors for company debts.

The entity theory is essential to the smooth operation of commerce through the separation of ownership and control. The owners’ finances should not be tied to the business in order to eliminate liability to the creditors.

The entity theory is often compared to the proprietary theory, which is essentially the opposite of the entity theory. The proprietary theory states that there is no fundamental difference between owners of the business and the business itself. Basically, the entity does not exist separately or otherwise from its owners.

The proprietary theory applies to sole proprietorships, where assets and liabilities of the business are owned by the owner. There is no limited liability under proprietary theory. The accounting equation under the proprietary theory is given below:

Assets – Liabilities = Proprietor’s Equity

The equation entails that the proprietor owns the assets and liabilities of the business operation.

Characteristics of an Entity

A corporation can be described with the following attributes:

1. It has its own name and exists as a separate entity or as an individual.
2. It is a going concern, which means it has a continuous existence notwithstanding changes in shareholders.
3. Shareholders have limited liability.
4. Obligations arise only from acts of agents and/or officers of the business.
5. Profits belong to the corporation until dividends are declared.

Origins of the Entity Theory

The entity theory is generally understood to have started around 1600 as promulgated by Lord Coke, where he declared that a corporation is a separate entity or an artificial person created by a sovereign power. It was fully expressed by Chief Justice John Marshall in the famous case, Dartmouth College v Woodward, 4 Wheat (US 7 51S). There was no consensus on whether the entity was created by law or a contractual relationship.

The case of Salomon v Salomon & Co. Ltd (1897) is also another milestone in the origins of the entity theory. Salomon was a sole proprietor who formed a limited company to incorporate his business. He appointed two of his sons and himself to be directors of the new company. He acquired shares and debentures from the company making him a secured equity holder.

However, in less than a year, the company faced challenges and developed some problems, and hence became due for liquidation. Salomon was at ease, as he thought he was a secured creditor/equity holder. The appointed liquidator was required to pay unsecured creditors first before paying Salomon after the creditors successfully argued that the company was just an agent for Salomon. Salomon was not pleased, as he thought he was a secured creditor and was entitled to be paid first.

Entity Theory and Its Accounting Treatment

Accounting developed from three growth phases, with the first being when accounting was centered on the owner, as he was also the manager of that business. The first phase is mainly relevant to the proprietary theory.

The second phase is where more businesses began to expand rapidly, and there was a need for debt to expand. It led to an increase in creditors, and accountants had to get more information from owner-managers. The last period that is relevant to the entity theory is where there was a separation of ownership and management. Accountants now prepare financial statements that are useful to a wide group of stakeholders.

The entity theory supports a clear separation of the owner’s finances and business activity. Accordingly, the accounting treatment for the theory shows a clear reflection of such distinction and autonomy. The entity accounts exclude the assets and liabilities of the owners in their personal capacity. The income statement calculates revenue for a specific period and a specific entity. The accounting relationship for the balance sheet under the entity theory is as follows:

Assets = Equity

Assets = Liabilities + Shareholders’ Equity

Assets are rights that flow to the entity and are owned by the entity. The source of assets is shareholder equity and liabilities. Equity can also be represented as the difference between assets and liabilities. Shareholders and creditors are both equity holders but have different rights attached to income, liquidation, risk, and control.

The income earned by an entity is the property of the entity until it is distributed to equity holders usually through dividends. The entity theory emphasizes how profit is determined. Profit is accountable to shareholders and the entity is responsible for satisfying the rights of equity holders. It inevitably makes the entity theory income statement-oriented.

The entity theory is most applicable to corporations where owners have limited liability, and there is a separate distinction between the business enterprise and its owners.

Conclusion

According to the entity theory, a corporate entity is commissioned by a country or state and enjoys all rights and privileges as granted by the law of the land. It exists independently of its shareholders, officers, creditors, employees, customers, government, and society in general.

Despite the criticism, the entity theory has shaped the accounting of limited liability companies and their disclosure requirements. There has also been a comparison of the entity theory and the proprietary theory concerning the connection between owners and entities.

Additional Resources

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

• Corporate Structure
• Going Concern
• Passive Ownership
• Shareholders’ Agreement
• See all economics resources