Finance And Insurance

Business Entity Concept



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The business entity concept holds that a business is a separate entity from its owner or owners, whatever the legal status of the enterprise may be. In other words, the personal activities and transactions of the owner must not be mixed with the activities and transactions of the business.

A business could take several forms, i.e. partnership, sole trader or corporation. These types of business have a certain legal status. For example, sole traders do not have a separate legal status, whereas a corporation has a separate legal status from the owner. That makes the corporation a separate legal entity.

♦  The business entity concept is an accounting principle that applies to all types of organisation.

It is so fundamental, that it is one premise for the accounting equation: Assets = Capital + Liabilities. Recall that capital represents the owners' financial input in the business. It is what the business owes to the business owner, in addition to liabilities from external sources (lenders or suppliers, for example).

The business entity concept is also central to the preparation of financial statements. It, along with key accounting assumptions, governs the preparation of statements of financial position and income statements.  One primary aspect of this assumption is that it governs the treatment of transactions by owners, even if the transactions are for personal purposes, as in the example of the sole trader.

Sole traders have one legal identity, that is, the sole trader is the same entity as the business. As a result, the sole trader has unlimited liability. However, the business entity concept has implications for the sole trader. The trader cannot treat business funds as his own piggy bank because of this principle.

If the owner (sole trader) deposits or withdraws money from the business, it is a separate from transaction from his personal account. For example, if the owner withdraws money from the business account for personal use, it is recorded as drawings. Any injection or reinvestment of profits would be regarded as capital in the accounting context.

Although profit is healthy for a business, from the business point of view it is viewed as a liability when establishing the financial position of a business. This is because of the enforcement of the business entity concept. Based on this, profit is a business' obligation to business owners. It would be up to the owner to decide what to do with the profit. It is not a matter of course that profit could be used for reinvestment, especially when there are multiple owners (investors).

 

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