Is the concept that the transactions of a business should be kept separate from those of its owners and other businesses?

The economic entity principle is an accounting principle that states that a business entity’s finances should be keep separate from those of the owner, partners, shareholders, or related businesses.

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An economic, business, or financial entity is any kind of organisation that was established for the purpose of trading or making profit.

According to the economic entity principle, all financial transactions must be assigned to a specific business entity, and entities cannot mix their accounting records, bank accounts, assets, or liabilities.

The economic entity principle applies to all financial entities, regardless of structure. The only exception is subsidiaries and their parent companies, which can combine their financial statements through a process called group consolidation.

The economic entity principle is sometimes also referred to as the business entity concept or the economic entity assumption. It is considered one of the core, fundamental principles of accounting.

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.

Business Entity Concept states that the business and the owner are two separate entities and accordingly must be treated separately. This concept is also called ‘Economic Entity Principle’ which explains that all the businesses, related businesses and the owners are separate entities and therefore these must be dealt with and accounted for separately. For example in a partnership firm, partners and the partnership/business are two separate entities. In case of corporations/companies, the company and its shareholders two separate entities. In case of sole proprietorship the business and the owner are two separate entities under accounting principle.

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.

Why Entity Concept in Important

Business Entity Concept is imporant because if the business transactions are mixed up with other businesses or owners transitions, then there will be a question mark on accounting information usability.  

1. Its helps in separate taxation both owner and business
2. It helps to measure performance both in terms
3. This concept helps to separately measure performance in terms of profitability and cash flows  
4. It helps business to compare its financials with other in the industry

Examples of Business Entity Concept

1. Mr. Aaron is running a partnership firm along with other partners dealing in tourism services. Mr. Aaron who is also the managing partner has withdrawn $ 25,000/- for his daughter’s marriage. Upon the conclusion of wedding ceremony, the managing partner has furnished necessary invoices of expenses incurred and claimed that these expenses which are incurred in connection with the wedding should be treated as business expenses. Now in accordance with the Business Entity Concept and principle, these expenses are personal and bearing no connection with the business. Therefore, these shall not be recorded as business expenses but the same shall be shown as ‘partner’s drawings, deductible from his capital account.

2. Mr. Ashbel is the owner of a pharmaceutical unit which manufactures I.V solution. His son has registered a construction firm and started business. Mr. Ashbel wants that his accountant should merge these two businesses for bookkeeping purposes.  Since these two businesses are separate entities, their records would not be merged under the business entity principle. The accountant is required to keep records of these two separate entities separately.