Global Journal of Management and Business Research, D: Accounting and Auditing, Volume 22 Issue 2

The goal of the FASB/IASB joint convergence project was to find underlying principals to guide the rules of standard setters. Toward this end, Van Mourik (2014) recommends categorizing firms according to whether they have limited liability or not, based on Demsetz (1967). Demsetz (1967, 358) defines the public corporation as having 3 characteristics, a legal personality, limited liability, and transferable shares. But, as this paper explains, limited liability is unnecessary for corporations to exist and can be privately contracted to a large degree. More importantly, Demsetz’ definition does not include entity shielding as a characteristic of a corporation when, without it, transferable shares could not exist. If stock markets can and have existed with limited liability, but not entity shielding, which is a more important characteristic of the firm? Instead, to determine the appropriate reporting perspective for each firm-type, academics should focus on how entity shielding affects firm-members’ claim to the net assets. Entity shielding uniquely identifies firm- type, cannot be privately contracted, and enables transferable shares, without which founders could not maintain personal liquidity. Entity shielding, not limited liability, should serve standard setters as the principle underlying determining the reporting perspective is required for each firm-type. II. E ntity S hielding Hansmann, Kraakman, and Squire (2006, 1336) explains that firms, like individuals, are legal persons in the sense that they “…enjoy the legal power to commit assets to bond their agreements with their creditors and, correlatively, to shield those assets from the claims of their owners’ personal creditors.”Firms differ from natural persons in that their firm-assets or “bonding assets are, at least in part, distinct from assets owned by the firm’s owners or managers, in the sense that the firm’s creditors have a claim on those assets that is prior to that of the personal creditors of the firm’s owners or managers.”In the quote, the authors use the term “owners” loosely to include sole proprietors, partners, founders, investors, shareholders, creditors, managers, employees, and customers. In this paper, “firm- members” is used to describe these groups. a) Types of Entity Shielding Hansmann et al. (2006, 1337-1338) call this separation of firm-assets from personal assets, “entity shielding,” defining 3 types. The first type is “weak entity shielding,” which provides the claims of the firm’s creditors priority over those of personal creditors. Weak entity shielding is found in all firms, including sole proprietorships and general partnerships. The second type is “strong entity shielding,” which provides weak entity shielding as well as two forms of “liquidation protection,” one that shields firm-assets from firm- members, like shareholders, and another that shields firm-assets from the personal creditors of firm-members. Strong entity shielding is found in business corporations. The third type of entity shielding, called “complete entity shielding,” provides complete liquidity protection by more strongly, relative to strong entity shielding, restricting firm-members and their personal creditors from any claim to the firm-assets. This form of entity shielding is found in nonprofit corporations. b) Liquidity Protection In strong and complete entity shielding, there are 2 types of liquidation protection. The first type of liquidation protection bars firm-members (e.g., shareholders, partners) from unilaterally withdrawing any portion of the firm-assets. Partnerships, through private contracting, have never achieved this type of long-term liquidation protection, as courts have been, “reluctant to enforce restrictions on free alienation of property if made in perpetuity.” (Hansmann et al. 2006, 1342) The second type of liquidation protection bars the personal creditors of firm-members (e.g., shareholders) from forcing withdrawals to satisfy personal debts. Partnership have not accomplished this type of liquidation protection, even in the short-run, as it cannot be accomplished through private contracting and, instead, requires special rules of entity law. For corporations to contractually shield firm-assets from the personal creditors of shareholders, it requires that corporations secure contractual waivers from all shareholders’ personal creditors. Since such waivers would increase personal borrowing costs, shareholders would have an incentive to conceal their personal creditors. This problem increases as more shareholders are added and shares are made freely transferrable. According to Hansmann et al. (2006, 1338), “These problems can be solved only by impairing the rights of personal creditors without their contractual consent [through] a special rule of property law respecting assets committed to the firm, and entity law provides that rule.” c) Benefits of Entity Shielding Entity shielding enables firms to embrace relatively longer-term and larger-scale projects with longer-term contracts, bonded by locked-in assets. Specifically, according to Ciepley (2013, 144), strong entity shielding enables the firm to“…increases its productivity (by enabling asset and labor specialization) and lowers its capital costs (by lowering the risk and monitoring costs of its creditors and investors).” Moreover liquidity protection enables tradable shares, which, in turn, enables founders to relinquish their personal assets to the corporation, yet maintain personal liquidity. Dari-Mattiacci (2017) documents anecdotal evidence on how entity shielding benefits productivity by examining differences between the Dutch East India Company (VOC), founded in 1602 and the British East The Effects of Entity Shielding on Claims to Assets: Implications for Financial Reporting 22 Global Journal of Management and Business Research Volume XXII Issue II Version I Year 2022 ( )D © 2022 Global Journals