What Is Entity Theory?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 12 March 2018
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In business, entity theory is a term used to demarcate the owners of the business from the business itself through the process of investing the business with a legal personality. That is to say that the business becomes a separate entity from the business owners, with its legal rights and responsibilities that can be distinguished from that of the owners. As such, the entity theory of business delineates certain responsibilities and actions to the business or corporation that can be legally separated from that of the owners of the business.

Under the entity theory, a business has its own assets that are clearly distinguishable from that of the owners. For instance, the house that the business occupies, the cars, the machinery and other forms of equipment as well as the finances of the business are separated from that of the owners. Entity theory requires the business owners to maintain a separate account that will remain personal to them, while the business account will be strictly used for the running and servicing of the business. The entity theory is very important, because it gives greater transparency to the activities in a business, which will come in handy when the business is looking for investors. It will also be useful for the purposes of accounting and to enable the business to obtain loans from financial institutions.

Another application of the entity theory is in terms of protecting the owners of the business and their assets from any liability that may occur as a consequence of the business operations. One aspect that various business have to take into consideration is the liability that may occur due to acts of negligence and other unforeseen factors. For instance, if someone slips and falls on a pool of water in a grocery store, the store itself will be held responsible and not the owner of the store. As such, any lawsuit will be between the store and the injured party.

The importance of the entity theory in this type of case is the fact that any damages that will be awarded to the injured party due to the accident will come from the finances and assets of the company. Without such a demarcation, the business owner would be responsible for the damages and would have to pay for it from his or her pocket. In terms of creditors, when the business no longer has the ability to keep up with its financial obligations it can be declared bankrupt. If the owners and managers have shown a good faith effort in the management of the affairs, however, they will not be held financially responsible.



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