What is the Business Entity Principle?
The business entity concept is an accounting principle that requires a business to be accounted for and treated as a separate entity from its owners. In other words, GAAP realizes that a business and its owner are two different things. The business is the entity that attempts to generate profits from its operations; where as, an owner is someone who attempts to generate returns on his or her investment in the business.
The business entity concept (also known as separate entity and economic entity concept) states that the transactions related to a business must be recorded separately from those of its owners and any other business. In other words, while recording transactions in a business, we take into account only those events that affect that particular business; the events that affect anyone else other than the business entity are not relevant and are therefore not included in the accounting records of the business.
The business entity concept states that the business is separate from the owner(s) of the business. Therefore the accounting records for even the simplest business, the sole trader, must be kept separate from the personal affairs of the owner or owners.
There are basically three types of business entity:
- sole trader
- limited company.
The principles of double-entry accounting apply to all forms of business organisation, as well as not-for-profit organisations.
A sole proprietorship is the simplest business structure and doesn’t require any legal forms in order to create. You can think of a sole prop as a one-man shop. There is only one owner who is unlimitedly liable for all the company’s actions.
A partnership is an organization of at least two partners. This too can be formed without any legal paper work. Different forms of partnerships like LLCs and LLPs have limited liability protection.
A corporation is the most popular form of business because it protects the owners with limited liability.
What is the Business Entity Concept?
The business entity concept states that the transactions associated with a business must be separately recorded from those of its owners or other businesses. Doing so requires the use of separate accounting records for the organization that completely exclude the assets and liabilities of any other entity or the owner. Without this concept, the records of multiple entities would be intermingled, making it quite difficult to discern the financial or taxable results of a single business. Here are several examples of the business entity concept:
- A business issues a $1,000 distribution to its sole shareholder. This is a reduction in equity in the records of the business, and $1,000 of taxable income to the shareholder.
- The owner of a company personally acquires an office building, and rents space in it to his company at $5,000 per month. This rent expenditure is a valid expense to the company, and is taxable income to the owner.
- The owner of a business loans $100,000 to his company. This is recorded by the company as a liability, and by the owner as a loan receivable.
There are many types of business entities, such as sole proprietorships, partnerships, corporations, and government entities.
Explanation of Business Entity Concept
The business entity is defined as the undertakings which are under the control of a single management. The basic purpose of the financial record keeping of business entity is to measure that how successful or otherwise the business has been in terms of profit or loss. While recording and bookkeeping, accountants want to know that for whom they are accounting. This concept starts with the fact that business unit is separate entity with its owner(s) identity. An accountant is duty bound to keep the business and its activities quite separate from its owners at the time of bookkeeping. Owners’ personal activities should not be incorporated or merged with the business activities. Only those economic events performed by the owners which bear direct connection with business and affect the entity are recorded. When the separate entity concept is applied, the accounting records are kept only with viewpoint of business unit and not the owners. The accounting equation which captures the essence of business entity concept is:
Liability + Capital = Assets
This principle accommodates the concepts and principles of consolidation of financial statements. A parent company having subsidiaries companies can prepare and issue consolidated financial statements under relevant accounting standards without harming the concepts of separate entity principle. Moreover, this concept does not refrain a business unit from separating the departments by functions within the unit.
Reasons for the Business Entity Concept
There are a number of reasons for the business entity concept, including:
- Each business entity is taxed separately
- It is needed to calculate the financial performance and financial position of an entity
- It is needed when an organization is liquidated, to determine the amounts of payouts to the various owners
- It is needed from a liability perspective, to ascertain the assets available in the event of a legal judgment against a business entity
- It is not possible to audit the records of a business if the records have been combined with those of other entities and/or individuals
Examples of the Business Entity Concept
Sarah owns an apartment complex and has a debit card attached to the bank account in which she receives her monthly rent. She uses the debit card on a regular basis to purchase food, clothes, cosmetics, and other personal items which are not business expenses. Clothing and food are personal expenses, and as a result the rental unit’s bank account lists several debits that are not related to its business operations. This results in complicated accounting and confusion as to how profitable the apartment complex really is.
Mark is a plumber with a contracting business and he is the sole employee of the company. He uses his savings from his landscaping work to purchase new equipment for the business on a regular basis. He does not document this on his business’s accounting as an owner contribution to the company. If he continues to use his own savings or other sources of income outside of the business to keep it operational, he may not be aware that his plumbing business is not self-sustaining and he is violating the business entity principal.
Importance/Need of Business Entity Concept
The business entity concept of accounting is of great importance because of the following reasons:
- The business entity concept is essential to separately measure the performance of a particular business in terms of profitability and cash flows etc.
- It helps in assessing the financial position of each and every business separately on a particular date.
- It becomes difficult and impossible to audit the records of a business if they are intermingled with those of different entities/individuals.
- The concept ensures that each and every business entity is taxed separately.
- The employment of business entity concept is very general among business organizations. If a company ignores this concept, it would not be able to compare its financial performance with that of others in the industry.
There are many reasons why financial statements should be prepared base on the Business Entity Concept. From the tax perspective, the owner and entity have different tax rights and responsibilities.
The entity is not responsible for paying the tax instead of its owner, and the owner is also not bear any responsibilities for its entity.
Well, sometimes it also depends on the type of entity that it is registered in. Partnership, limited liabilities, or else. But, in general, the owner and entities have different tax liabilities.
Because of these different liabilities, accounting information must be separately recorded, taxes are separately submitted.
They have different legal responsibilities. The owner owns the bank if they borrow, not the entity. If the money is not paid back, the bank sued the owner, not the entity
When the company liquidates, creditors, bankers, and other parties could have the right to enforce the company to pay the debt. But they can’t enforce the owner to pay the debt on behalf of the entity.
Again, this also depends on the type of regal entity that the company register in and how it is interpreted according to the local law.
In general, the owner and entity have different legal liabilities and having separate records of assets and liabilities are required by most of the local law as well as accounting standard.
The benefit is when there are legal or financial problems with both the entity or its owner.
Small businesses, sole traders and the economic entity principle
Small businesses and sole traders often experience more difficultly with the economic entity principle than other types of companies, as it is common for sole traders to mix personal and business transactions.
This is particularly likely at the start of a new company, when owners often use their own bank accounts or credit cards to make purchases for their business. However, as a freelancer, sole trader, or small business owner, you must be sure to follow the economic entity principle and keep your finances separate from those of your business.
For example, most small businesses require some initial investment from the owner, unless they secure enough capital from crowdfunding or a business angel. Any money put into the business by an owner should be recorded as capital investment.
If you make a purchase for your business on a personal credit card at a later date, this amount should also be recorded as capital investment, as this gives a more accurate picture of your company’s financial position and separates your personal and company finances.
Economic entity principle vs. limited liability
Limited liability creates a legal distinction between a business, its owner, and its shareholders. Like the economic entity principle, limited liability separates a business’s finances from the finances of the owners or shareholders; however, there are several key defences between the two concepts.
Firstly, the economic entity principle applies to all businesses, regardless of structure. Limited liability does not apply to certain business structures, such as a sole trader.
Secondly, whereas the economic entity principle is a guideline for accounting standards, limited liability is a form of legal protection. The economic entity principle therefore only separates an owner from their business in terms of financial accounts, whereas limited liability prevents an owner or shareholder being held responsible for a company’s debts or losses.