Entity Theory

What is Entity Theory?

Entity theory is an accounting concept that states that the business activity and transactions are separate from those of the owner.

From an accounting perspective, it dictates that a business's transactions, assets, accounts, and liabilities should be distinctly recorded apart from the owner's finances.

In a broader business context, entity theory establishes that the owners of a business are structurally separate entities from the business itself, thereby shielding them from personal liability for business debts.

Separating personal and business activity allows entity theory to calculate the business's financial position accurately. Due to the problems it creates in private agencies, the theory is invaluable in limited liability companies (LLCs) accountancy. 

Furthermore, while simplifying accounting, the theory has many fundamental problems making it useless for most businesses.

Nevertheless, it remains a foundational concept for accurately accounting for a company's assets and transactions. The entity concept, which simplifies complex calculations by treating entities as separate units, has been entrenched in financial practices since the 19th century, underscoring its significance in the realm of finance.

Understanding the Entity Theory

In entity theory, a firm's operational individual or group is separated as a legal and accounting entity, thus creating an imaginary person.

From a legal and accounting perspective, interacting with those individuals or groups is considered interaction with the firm rather than the people making separation of responsibility and legal ownership of assets and liabilities possible. 

The activities of operating individuals are recorded separately from legal ownership. Consequently, accounting of transactions within the firm is done collectively.

What are the benefits? The following are the ways businesses benefit from the theory:

1. First, it allows transactions to be collectively calculated as separate entities. This means that the calculation of net profit or losses and the net value of the underlying assets can be simplified, aiding in future decision-making for the company.
2. The business is a separate entity by law that allows firms to purchase or own assets, properties, contracts, debts, etc.
3. Owners being a separate entity from the firm allows businesses to get sued without owners or management being sued individually.

Formula

Given that a business follows the entity theory, the accounting equation for a firm's total assets is the sum of two separate entities: the net liabilities of the company and the stockholder's equity. 

That is, 

 Assets = Liabilities + Stockholders’ Equity

Where,

• Liabilities: Net current and long-term debts and obligations
• Stockholders' Equity: Total available assets for shareholders after liabilities

This equation outputs the total assets that shareholders own when liabilities of the firm in the form of debt or obligations are subtracted from the total assets owned by the business separating owners from the debts and obligations faced by the company.

Referenced from George F. Canfield's paper on "The Scope and Limits of the Corporate Entity Theory." 

Characteristics of an Entity

A corporation is denoted by its unique name and continued existence as a separate entity regardless of shareholder changes. The corporation owns the profits until dividends are established, with shareholders having limited liabilities.

An entity is an isolated form of "person" containing any number of separate individuals inside it. Any interaction is done with the entity as a whole rather than the individuals within it.

The theory isolates owners, making them disconnected from their respective businesses, which is counterintuitive as their interests align with their corresponding businesses' interests or goals.

Although making calculations easier, the theory has many flaws, making its use cease to exist, especially in the case of limited liability companies or private companies. Nevertheless, this theory has been developed and established since the 1900s, making it fundamental for businesses, finance, and accounting. 

Origins of the Entity Theory

Entity theory allegedly started around the 1600s, promoted by Lord Coke, who stated that a business or corporation is a separate individual entity. 

Chief Justice John Marshall later fully expressed this theory in the famous Dartmouth College v Woodward, 4 Wheat(US 7 51S). The creation of an entity via law or a contract wasn't stated.   

Another important event in entity theory was the case of Salomon v Salomon & Co. Ltd in 1897. Salomon was the founder of a company, Salomon & Co. Ltd. When creating his business, he placed himself and his two sons as the directors of the newly formed company.

Salomon acquired a majority of his company shares to make himself a secured equity holder. Unfortunately, his company faced some challenges within less than a year, and the company became due for liquidation.

Salomon expected to be paid before other unsecured creditors as a secured creditor. Still, the creditors argued that the company was just an agent for Salomon, and subsequently, the liquidator was required to pay unsecured creditors before Salomon, a secured creditor.

Ultimately, the courts sided with Salomon.

Entity theory has since been considered a fundamental theory in finance and accounting, though it has limited use in business.

Criticisms of the Entity Theory

The theory has a handful of key issues.

First, even though it has been established since the 19th century, it still has critics who point out a few problems:

1. It requires individuals and groups of a given firm to assign themselves a single separate entity independent from its owners or shareholders. That is, the business entity interacts with a single imaginary individual.
2. Not only does entity theory require individuals to believe in an imaginary entity, but it also isolates owners and shareholders from their businesses. As a result, entity theory fails to establish a relationship between owners and their businesses. 
3. The owners and shareholders are linked with their respective businesses as a way to extract profits, meaning that owners and the company have similar interests. Besides capital, owners and shareholders sometimes contribute to the company with time, effort, knowledge, etc. 
4. Employees have similar interests as the firm itself since the firm's performance is sometimes directly linked to their success.
5. Both entities, owners, and their respective employees carry the risks of a business to some extent—owners for their indirect losses and individuals for indirectly risking their jobs.   

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