There is a basic theoretical assumption that garnered plenty of criticisms. However, some continue to use it because it is beneficial to LCC or Limited Liability Company accounting practices and the current corporation statuses as juridical people.
The entity theory tells us any economic activity that a business will conduct is totally separate from the owners. It means that the owners do not get accounted for relative to any company’s activity. These company activities are independent of the owners under a limited liability premise or the ownership separation from control. Hence, if a problem involving loans and liabilities arises, the creditors cannot go after the owners and their personal assets because the entity theory says that they are not responsible for these.
Now, we understand why it receives so many criticisms, and we see that this is mainly because the relationship in practice realism is not enough. Later on, we will explain more on why people do not agree to this.
What is the entity theory?
Sometimes, an owner’s limited liability for some businesses is essential, especially when it comes to ownership versus control. Entity theory separates the owner and company liabilities with a baseline that separates the owners from the business finances. Entity theory is an essential factor that affects all parts of commerce.
Entity theory and accounting
The entity theory is not only critical in terms of commerce all around the world. It is also essential for modern accounting. Here is the simple balance sheet accounting equation where we base it from:
Assets = Liabilities + Equity of Stockholders
Where:
Liabilities = All current and long-term debts and obligations
Equities of Stockholders= Assets available to shareholders after all liabilities
Tell me more about this theory.
The entity theory states that liabilities are equities with rights and legal standing independent from each other within the business. In terms of accounting, this theory also tells us that they get to keep the obligations, assets, revenues, any other expenses, and any other financial aspects of the company independent from the company owner’s personal money and how he uses it. Hence, it is clear that the company’s identity, owners, and managers are not a single entity but separate. Furthermore, the law sees these corporations are juridical people. It means that the company can have assets and properties. It can also borrow money, have contracts, and many more. So, it can also receive a lawsuit and be sued. However, if the company ever gets sued, the owners and managers are in the clear.
Why the criticism?
A company is not really an independent entity, and we know it. Where does the company revenue go? It goes to the owners or managers. So, we cannot say that they are not tied in the company. They are significant stockholders. Anything that owner that invests in the company will always expect a return. So, even when the entity theory has already been around since the 19th century, some use it, but they are not many because of criticisms. Criticisms of Entity Theory