What is Entity Theory?

Entity theory is the concept that the transactions associated with a business should be separated from those of its owners. Under this theory, the owners are not responsible for the liabilities of the organization, so their assets should not be commingled with it. This means that separate accounting records should be maintained for the business that does not include any of the assets or liabilities of its owners. Only by doing so can you discern the financial results and financial position of the business.

Problems with Entity Theory

Entity theory breaks down in the case of a sole proprietorship, where the owner is personally responsible for the liabilities of the entity. It can be difficult for the owner of a sole proprietorship to engage in the accounting needed to fully separate the accounting transactions of the business from his or her personal affairs.