Updated July 13, 2023
What is Business Entity Concept?
The term “Business Entity Concept” states that a business and its owner are separate entities, so their transactions must be recorded separately. In other words, while recording accounting transactions, only events that affect the business are considered, and events that are irrelevant to the business are not included in the accounting records.
Without this concept, various entities would have mixed-up business records, making it difficult to distinguish the financial performance of a single business.
Examples of Business Entity Concepts
Let us look at the following examples to understand the application of the business entity concept:
Example #1
Let us assume Jason has rented a commercial space with 4 rooms for $2,000 monthly. Three rooms are used for business, while he uses one for personal purposes. Therefore, according to the business entity concept, $1,500 (rent of 3 rooms) should be recognized as a valid expense.
Example #2
Let us assume that Alex runs a sole proprietorship firm. Recently, he has lent a sum of $200,000 to his own firm. According to the business entity concept, the firm would record the amount as a loan or liability that needs to repay.
Example #3
Let us assume that Jessica is the owner of a company. She uses two different credit cards – credit card no. 1 for paying business expenses and credit card no. 2 for personal expenses. She paid her company’s $500 electricity bill using her credit card no. 2. Ideally, the company’s electricity bill should have been paid using credit card no. 1. According to the business entity concept, the payment of $500 would therefore be recognized as Jessica’s additional capital contribution to the business.
Types of Business Entity
The business entities are broadly categorized into four major types, as shown below:
- Sole Proprietorship: It is the simplest form of business entity that one can set up as it doesn’t require legal forms. In this type of entity, only one owner is legally liable for business-related activities.
- Partnerships: This type of business entity involves two or more individuals. A partnership firm can also be formed without much paperwork, just like a sole proprietorship.
- Limited liability companies: In this type of business entity, administration, and tax treatment are as simple as that of a sole proprietorship, while the limited liability protection is similar to that of a corporation. It is more complicated than a sole proprietorship and less complex than a corporation.
- Corporations: This entity type, wherein shareholders own the business while a board of directors manages and operates it, is considered the most complex. It is typically formed for managing a large operation.
Importance of Business Entity Concept
The business entity concept is an important aspect of financial accounting. Some of the key reasons for the concept are discussed below.
- It helps keep track of the business owner’s actions wherever company funds are involved. It facilitates differentiation of the use of business capital for business purposes and personal expenditure. In this way, it increases the owner’s liability and makes them more accountable for using funds.
- It becomes very useful during tax filing as personal and business records are maintained separately. Otherwise, the intermingling of the records would make the tax filing process more complicated, as the determination of cash flow and profitability would be challenging.
- It allows one to determine a particular entity’s financial performance. In other words, separate accounting records can determine how well an entity has performed vis-à-vis its peers. Investors usually show interest in a company’s financial reports as they can compare them with others in the industry to evaluate investment opportunities.
- The shareholders of the business must have access to the accurate financial data of the entity, as it is critical for making certain business decisions.
- If the financial transactions are not recorded separately, it becomes difficult for auditors to evaluate the accounting information efficiently. The sole purpose of an audit is to assess the financial integrity of a business, and the intermingling of records fails this purpose.
- It can be helpful in competitor comparison, a critical performance metric of any business. Competitor analysis is a key component of the SWOT analysis as it helps determine the business’s positioning in the industry. In addition, it can use to identify what works for the business and what needs to be changed. This is only possible with proper accounting records of the entity.
- Having separate financial records can be handy if the business needs to go into liquidation. It allows the stakeholders to ascertain their compensation in the event of liquidation.
Key Takeaways
Some of the key takeaways of the article are:
- In accounting, the business entity concept states that business owners should ensure that business and personal transactions are recorded separately.
- Some of its benefits include easier tax filing and increased owner accountability.
- It allows the stakeholders to analyze the financial performance of a particular business accurately.
- The business entity concept is an accounting practice rather than a legal requirement.
Conclusion
According to the business entity concept, the firm would record the amount as a loan or liability that it needs to repay. It helps maintain the company’s financial integrity and transparency. It ensures that the financial statements of a business reflect its true performance. Besides, there are various other benefits for the stakeholders, auditors, and others involved in the business.
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