What is Business Entity Concept?
The term “Business Entity Concept” states that a business and its owner are two separate entities, and hence their transactions must be recorded separately. In other words, only events that affect the business are considered while recording accounting transactions, and the events that are not relevant for the business are not included in the accounting records. In the absence of this concept, the business records of various entities would get mixed up, making it tough to distinguish the financial performance of a single business.
Examples of Business Entity Concept
Let us look at the following examples to understand the application of the business entity concept:
Let us assume that Jason has rented a commercial space with 4 rooms for $2,000 per month. Three of the rooms are used for the 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 of the business.
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 amount would be recorded as a loan or liability that the firm needs to pay back.
Let us assume that Jessica is the owner of a company. She uses two different credit cards – credit card no. 1 for the payment of 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 can be broadly categorized into four major types as shown below:
- Sole Proprietorships: It is the simplest form of business entity that one can set up as it doesn’t require any legal forms. In this type of entity, there is only one owner who 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. Basically, it is complicated than a sole proprietorship but less complex than a corporation.
- Corporations: It is the most complex form of business entity, wherein shareholders own the business while it is managed and operated by a board of directors. This type of entity 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 in keeping 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 the use of 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 be used to determine how well an entity has performed vis-à-vis its peers. Investors usually are interested in a company’s financial reports as they can compare them with others in the industry to evaluate investment opportunities.
- For the shareholders of the business, it is very important that they 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, then it becomes very difficult for the auditors to evaluate the accounting information efficiently. The sole purpose of an audit is to assess the financial integrity of a business, and intermingling of records fails this purpose.
- It can be helpful in competitor comparison, which is a critical performance metric of any business. Competitor analysis is a key component of the SWOT analysis as it helps in determining the positioning of the business in the industry. In addition, it can be used 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 in case the business needs to go into liquidation. Basically, it allows the stakeholders to ascertain their compensation in the event of liquidation.
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 practise rather and not a legal requirement.
So, it can be seen that the business entity concept is applicable to all types of business entities. 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.
This is a guide to Business Entity Concept. Here we also discuss the definitions, types, and importance of the Business Entity Concept along with the examples. You may also have a look at the following articles to learn more –