Definition and explanation
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.
This concept is very important because if transactions of a business are mixed up with that of its owners or other businesses, the accounting information would lose its usability.
The business entity concept of accounting is applicable to all types of business organizations (i.e., sole proprietorship, partnership and corporation) even if a law does not recognize a business and its owner as the separate entities.
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.
Some examples of the application of business entity concept are given below:
Mr. John has acquired a floor of a building having 3 halls for $1,500 per month. He uses two halls for his business and one for personal purpose. According to business entity concept, only $1,000 (the rent of two halls) is a valid expense of the business.
The owner of a company lends loan to his company. It would be strictly recorded as company’s liability and that has to be paid back to the owner.
Mr. Sam owns a company. He uses two different credit cards – one for the payment of business expenses and one for the payment of personal expenses. He pays $200 as the electricity bill of his company using his personal credit card. According to business entity concept of accounting, the electricity bill of the business should have been paid using company’s credit card. The payment of $200 using personal credit card would therefore be considered as the contribution of additional capital by Sam.