The business entity concept differentiates between the financial transactions of businesses and their owners. It requires maintaining separate accounting records for both.
Let us discuss the business entity concept, how it works, and its importance for a business.
What is Business Entity Concept?
The business entity concept states that the transactions of a business and its owners should be recorded separately.
It also states that the financial transactions of a business should be kept separate from other businesses (subsidiaries, parent companies).
These financial transactions include revenue, expenses, purchase/sale of assets, taxation, loans, and equity transactions.
It means all financial transactions affecting a business and its owners should be appropriately assigned to the business and the owners separately.
It means a business and its owners should be responsible only for their relevant transactions.
The business entity concept applies to accounting, taxation, and management aspects of a business. It can be applied to all kinds of entity structures including a sole proprietorship.
How Does the Business Entity Concept Work?
The business entity concept begins with creating separate accounting records for the business and its owner.
Each financial transaction should be recorded with a reference to the usage of the business or owners. Whenever a financial transaction occurs for both, it should be allocated properly.
For instance, if a sole proprietor is using house space for office work, it should be rented to the business at the market competitive rates.
Similarly, every financial transaction should be recorded appropriately. The aim is to set up a fair accounting system.
After recording all transactions, the financial statements of the business would contain only data relevant to the business. It means any financial transactions related to owners would be separated.
This will keep a fair accounting record of the business as well as compliance with the taxation and regulatory requirements.
Examples of Business Entity Concept
We can explain the business entity concept with the help of a few simple examples.
Suppose Mr. A has obtained a personal loan of $ 25,000 that he intends to use for the business. The $25,000 amount used by the business should also be recorded as debt to the owner.
Suppose Mr. A owns a vehicle that he uses for personal and business purposes in routine. All vehicle maintenance, gas, and lease expenses should be apportioned according to the mileage usage fairly.
Now suppose, Mr. A withdraws $10,000 from the business other than the profit (or dividend) amount. This owner’s draw would reduce Mr. A’s share capital invested in the business.
Similarly, every financial transaction involving the business and its owners should be recorded in a way to separately prepare the financial records.
Types of Business Entities and the Application of Entity Concept
The business entity concept applies to all businesses and every entity structure. It aims to prepare a fair accounting record for a business and its owners.
Let us see some common entity types and the application of the entity concept for each.
When a single owner registers a business and owns it, it is called a sole proprietorship. This entity structure comes with unlimited liability for the owner.
The entity concept says all accounting records should be kept discretely so that the personal and business transactions do not get mingled.
This is the entity structure where two or more persons (or entities) are owners of a business.
The entity concept applies to the partnerships as well. It requires creating separate financial records for all transactions for the business and its partner owners.
Limited Liability Companies (LLCs)
A limited liability company is owned by one or more owners (called members). As the name suggests, owners are protected against unlimited liability claims unlike in a sole proprietorship or partnership.
By default, an LLC should keep financial records separate from its owners. This entity structure is easier to apply the entity concept.
A corporation is a complex entity structure that can be owned by shareholders and managed by its directors. The directors may or may not include major shareholders of a corporation.
Legally, a corporation is a separate legal entity from its owners. Thus, a corporation entity type fulfills the entity concept requirements by default.
The business entity concept is a simple one but it may become a complex practice for different entity structures. However, it can be practiced for any kind of entity structure.
Business Entity Concept in Accounting
It is the fundamental concept of applying the business entity concept. The concept applies at levels of a business including accounting, taxation, and other financial concepts.
For accounting purposes, the concept demands that financial transactions for owners and businesses must be recorded separately.
For instance, a business owner should not use a personal credit card to make business purchases. If a personal credit card is used, it should be considered a business loan.
Importance of The Business Entity Concept
Here are a few important points when applying the business entity concept.
Improved Accounting Records
Keeping separate bookkeeping records for owners and businesses requires special skills and effort. However, it results in improved accounting data for the business overall.
Tidy accounting records can lead to clean financial statements of the business. Thus, a business will witness an improved financial system overall.
Compliance with Taxation
Separate accounting records mean easier taxation compliance by the business and its owners.
It is particularly important for small businesses with sole proprietorship and partnership structures. However, the same concept applies to LLCs and corporations as well.
Improved Audit Results
The business entity concept improves the financial record-keeping efficiency of a business. In turn, that improves compliance and audit results of the business.
When applied at levels, the business entity concept can avoid audit errors that could prove costly otherwise.
Business Performance Appraisals
Business owners aim to generate profits from a business by utilizing resources efficiently. The business concept helps them achieve their goals of improving business performance.
The availability of key business performance indicators means easier performance appraisals for owners.
Separate Records for Subsidiaries
Apart from the owners, the business entity concept applies to subsidiaries of the same group as well.
Subsidiary financial records are consolidated by the parent company. However, each subsidiary must prepare financial records separately that comply with the legal requirements and fulfill the business entity concept as well.
Easier Reporting to Stakeholders
The availability of financial records for a business and its owners means easier reporting to all stakeholders of a business.
It is particularly important for corporate and LLC business structures where a business must report to different stakeholders including shareholders, directors, regulators, creditors, and so on.
Limitations of the Business Entity Concept
For small businesses, keeping a separate financial record of all personal and business transactions can be overwhelming. Although it is a legal requirement as well.
Similarly, the business entity concept is already embedded into accounting practices of different entity structures like LLCs and Corporations. The additional work does not require separate accounting practices.
Whenever small businesses apply the entity concept, they’ll require detailed bookkeeping records. It will take time and effort.
Also, separating personal and business accounting tasks can be an overwhelming task for many business owners as it requires special accounting skills.