What is a business entity assumption?

Definition: The economic entity assumption is an accounting principle that states businesses should be treated as separate economic entities from other companies as well as their owners.

Across the globe, millions of entrepreneurs run great businesses that deal in all manner of activities. These entrepreneurs need to pay taxes and, occasionally, an external party may want to do a valuation of the business. For the valuation to happen, financial records of the business must be available for perusal. Additionally, the financial records must tell an untainted story about the finances of the business. Here is where the economic entity assumption comes in.

This is a general principle that accountants follow whereby they treat the affairs of the business separately from the affairs of the business owner. If the business is a sole proprietorship, it is highly likely that the owner himself/herself keeps all records, including finance-related. However, the economic entity assumption holds that the business owner must not mix his records with those of the business. This assumption is crucial here because it is easy for a sole proprietor to mix up the records.

The principle applies to large companies too. Say, for example, an agribusiness company is involved in operating an orchard as well as a dairy farm. Obviously, these two operations would run as two distinct divisions. Each division earns different sums in revenue and the expenses are unique. Under the economic entity assumption, the financial records of each of the divisions should be kept separately. For example, an expense incurred by the orchard should not appear under the dairy farm.

Why is the Business Entity Principle Important?

Many stakeholders have interests in different businesses. For a sole proprietorship, the government may want to know the nature of the finances for tax purposes.

In this case, the economic entity assumption ensures that the transactions that appear in the financial records of the business are actually those that reflect the operations of the business. The principle facilitates the clarity of the records and makes it easier to audit the records.

Economic Entity Assumption for Sole Proprietorships

Take this example. Quentin owns a bicycle shop that is located a few meters away fromhis parents’ house. He keeps all the records of sales and expenses neatly. The most recent records reads:

• Bought a new stock of 10 bicycles
• Brought in spare parts from the city
• Expanded the shop to accommodate more stock
• Hired an assistant

Sure, all the entries made by Quentin are valid as far as the business is concerned. This is because they are related to the business. As long as the activity is directly related to the business, there is no doubt about it being included in the records.

It would not be okay if Quentin added items like:

• Took one week on vacation in Florida
• Replaced the broken screen to the iPhone
• Rented an apartment to move out of the parents’ home

Well, these are not related to the business in any way. Instead, these are personal expenses probably done with money from the business’ coffers. If Quentin files taxes and captures these items as operational expenses for the bicycle shop, he would be breaking the tax law. Notably, the principle of economic entity prevents business owners from filing the wrong amount to the IRS. That is why it is advisable to keep separate bank accounts; one for the business owner’s personal finances and another one solely for the business.

Economic Entity Assumption for Corporations

Corporations are huge and the owners are separated from the business since incorporation. However, the economic entity assumption still applies especially when the company runs various divisions. Under the assumption, each division or department must keep separate financial records. This makes it easier for auditors to appraise the company in the event of a major development like a takeover or a merger.

If an investor wants to put money in the business, he/she would want to be sure that the asset would recoup the capital. The only way to get the assurance is to peruse through financial records. However, this can be hectic if the records are in a chaotic jumble.

The business entity assumption is an accounting principle that makes a legal distinction between the transactions carried out by a business and the transactions of the owner. It might also sometimes refer to the separation of different divisions in a company. Each unit maintains records of its operations and is responsible for its transactions.

This does not only apply to the larger entities but also the smaller enterprises as well. A sole proprietor should keep his personal transactions separate from business transactions.

This assumption is also valid for businesses with multiple operations. For example, a company might have two businesses – an airline and a hotel. It is expected that the company would present the financial statements of these two entities separately so that the true value of the company can be ascertained.

Importance of the Business Entity Concept

The business entity concept is important for a variety of reasons including the following:

• Business performance of various segments or divisions is measured separately.
• Audit becomes an easier process if separate financial records are maintained. If the records of different business units were intermingled, it would be a nightmare for the auditors to perform their evaluations.
• Each business unit is taxed separately.
• If a company violates this principle, comparing its financial performance of it with others in the industry would become difficult.

Limited Liability

It is important to note the difference between limited liability and the business entity principle.

Limited liability is a type of legal structure for a business where the owner’s personal assets are not at stake in case the company makes losses and needs to pay its creditors. In other words, it creates a legal distinction between the owner and the business in a way similar to what the business entity assumptions do.

However, there are a few notable differences between the limited liability and the business entity principle:

• First, the business entity principle applies to all types of business entities including sole traders. The limited liability does not apply in the case of a sole trader.
• Second, Limited liability is a form of legal protection. Whereas, the business entity principle achieves the separation of only the financial transactions of the owner and company.

Types of Business Entities

The most common types of business entities are:

Sole trader/Proprietorship

This is the simplest and basic form of a business entity. It is run by an individual for his own benefit and he does not have to share his profits with anyone else.

As per the business entity assumption, the financial transactions of the owner and business are treated and accounted for separately. This means that the owner’s personal assets and liabilities do not have to be included in the records of the company.

However, the sole proprietorship does suffer from having unlimited liability. This means that in the case of a company going bankrupt, the owner will be personally liable to pay the dues of the company from his personal assets. This is because the business entity principle does not talk about the separation of any legal issues, it merely requires that the financial transactions of the owner and company are recorded separately.

Partnerships

A partnership can be of two types – a general partnership and a limited liability partnership.

A general partnership is an agreement between two or more people coming together to run a business. Each partner has a certain portion of capital invested whether it is in the form of money, skill, or labor, and then shares in the profits and losses as per agreed upon terms. A general partnership is similar to a sole trader in terms of having unlimited liability, which means that the partners are personally liable for the debts of the company.

A limited liability partnership does away with this problem. The owners and the business entity are legally two separate entities. Therefore, if a business is bankrupt, the partners do not have to lose their personal possessions as in the case of a general unlimited liability partnership.

Limited Liability Company (LLC)

These are business entities that combine the pass-through taxation benefit of a sole trader with the limited liability benefit of a corporation. Due to the high flexibility in its structure, registering an LLC is a long and arduous process.

Corporation

An article of incorporation is used to register and form a corporation. The shareholders have limited liability and the employees enjoy tax-free benefits such as health insurance. Corporations have a perpetual life, which means that ownership can be transferred to future generations by the existing shareholders.

The downside of a corporation is that they are subject to what is called “double taxation”. The first income tax is paid by the corporation on the profits it makes, and the second tax is paid by the shareholders on the dividends they receive. Another drawback of a corporation is the high cost it takes to set them up and that they are usually more regulated by the government.

Examples of Business Entity Concept

Here are some examples of when this concept can be violated:

• Tom uses his company’s credit card for personal expenses such as laundry and dining out. He argues that these expenses are business-related as he wears clean clothes to his office and has a meal or two in between his meetings. As per the business entity principle, these are not business expenses and should be accounted for as owner withdrawals or drawings from the company.
• Bob currently owns a donut shop and is considering buying a pizza shop that someone else has opened next door. After Bob goes through the acquiring process, he merges the financials of both entities into one single QuickBooks file. Bob is clearly in violation of the business entity principle here as he has not treated both the donut shop and pizza shop as separate entities. As per the stated principle, the correct way would be to recognize that both entities are separate and their financial transactions should also be accounted for separately.

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