According to the entity concept, a business and its owner are two separate entities in accounting. As a result, the business and the owner’s accounts are also two separate entities and must be maintained. If the business is a partnership, then the partners and the business are treated as separate entities.
If it is a large business and there are different related businesses associated with it, each should be treated as a different entity. This business entity concept is also known as the Separate Entity or Economic Entity Concept).
Understanding the business entity concept is crucial because if business transactions get mixed with its owners’ transaction details, the overall accounting information will be of no use. This post will unravel the mystery behind what entity concept is and why it is considered important.
Business Entity Concept Definition
The concept in which an entity’s owner comprises different legal liabilities compared to the entity’s obligations is an entity concept.
The undertakings which are under the control of single management are called a business entity.
Financial accounting is done to understand how successful the business is concerning profit and loss. While managing the accounts or recording transactions, the accountant should be clear about who they are doing the accounting.
For ease of accounting, the accountant always maintains different accounts for the business and the owner.
The personal transactions of the owner should never be mixed with the activities of the business. The entity concept is a principle that makes a legal distinction between accounts of a business and its owner’s accounts.
This principle applies to small and large businesses, with different businesses under its wing alike. Let us now have a look at different types of business entity-
Different Business Entity Types
The different types of business entities are:
1) Sole Trader or Proprietorship
It is the first and most basic type of business entity.
One person runs it, and the profits are all for himself. According to the business entity principle, though a single person runs the business, they should be considered as two separate entities for all accounting purposes.
The accounts of the business and the owner and all the transactions are considered separately.
One drawback of this is that if the businesses end in loss, then the owner is solely responsible for bearing the assets’ losses.
There are two types of partnerships in the entity concept, and they are:
a) General Partnership
Not just money but skill and labor too. The profits are shared upon pre-agreed terms depending on the capital, skill, and labor they have invested in the business.
Like sole proprietorship, the partners can cover any loss from the business from their savings or assets.
b) Limited Liability Company
Limited liability gives a legal structure for the business where the owner’s assets are not used to cover its business loss.
The sole proprietorship concept makes a distinction between the company accounts and the owner’s accounts. Limited liability takes it a step further by giving it a legal structure. According to this, the company alone is legally responsible for covering up for its losses in business.
The owner’s assets remain protected against the company’s losses. These business entities combine the sole proprietorship’s pass-through taxation benefits and the corporation’s limited liability benefit.
One drawback here is that registering a limited liability company is a long and tedious process.
An article of incorporation forms a corporation.
The shareholders have limited liability in the loss of the corporation.
The downside is ‘double-taxation’ where the company pays tax on its profits, and then shareholders pay tax on the dividends they get.
Benefits of the Business Entity Concept
- This concept is necessary to separately quantify the performance of a business in cash flows and profit.
- It facilitates the assessment of each business’s financial position separately on any given day at any given time.
- The intermingling of the accounts of different businesses and partners makes it difficult to audit the records.
- It is easier for taxation as each business is separately taxed.
- It compares its financial performance with other competitors if the business account is not a completely independent entity.
Final Thoughts about the Entity Concept!
The business entity concept is one of the most basic principles of accounting. This practice makes it easier for the accountant to record the transactions.
It is also easier for anyone who wants to check its profit or loss if the person’s and the business’ transactions are not intermingled. It was basically with this point of view in mind that the concept emerged.
But as time passed, legal matters also came into account.
Keeping these two entities separate also helped keep the business’s liability and the owners separate in case of a loss. The tax calculation also became more straightforward when the business was a separate, independent entity from the owner.
All these reasons only added to the benefits of the business entity concept. This concept is followed worldwide now and is one of the first and most useful concepts of accounting.
What is your entity concept definition? Share with us in the comment section below.