Business Entity Concept Definition
The business entity concept declares that a business stands independently from its owner, and hence the two should be treated as separate entities when recording transactions. Therefore, all business transactions (income, expenses, assets, liabilities, and equity) must be kept separate from the owner’s personal account to ensure accurate accounting records.
In accounting, the business entity concept increases the owner’s accountability whenever the business capital is utilized for personal use. It compels the business and owner to be responsible for their separate financial obligations. This principle can also apply to the owners of multiple companies.
- The business entity concept is a principle of accounting that implies business owners should keep personal and business records separate. It can assist in maintaining accurate accounting records and ensuring easier tax filing.
- This concept allows individuals, whether inside the company or not, to analyze the financial performance accurately.
- The business entity concept is not the same as the corporate veil. It’s considered an accounting practice rather than a legal one.
How Does it Work?
The business entity concept should be applied to every type of business (sole proprietorship, partnership, and corporation) to retain financial integrity for those involved in the company. The purpose of the concept is to ensure the business’s financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. reflect the company’s performance. This allows for shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. and other stakeholders to determine its financial performance and positioning.
In accounting, the business entity concept prevents personal and business expenses from becoming entangled, which can interfere in determining the correct taxable information. Any money moving to or from the company should be recorded in a separate accounting journalAccounting JournalAccounting journal, often known as the book of original entry, is first used to record the company's accounting record whenever a financial transaction occurs. It's difficult to comprehend, yet it's crucial in business operations and accounting. to avoid confusion.
Examples of Business Entity Concept
- Owners Draw – Let’s say, for example, you’re the owner of a business, and you decide to withdraw money to pay for your child’s tuition. Such a withdrawal acts as an expense for the business as it allows a loss of capital to fund a personal expense. The transaction must be written as an owner’s draw to signify the transaction is for personal use. This doesn’t include paying yourself a salary, which would be considered regular wages.
- Loaning Money – If you’d like to lend personal money to your business, it will be considered a liability to the company. The loan amount will be treated as a debt that must be paid off as per the loan terms with consequences for missed payments. This can typically be done through an attorney.
- Contributed Capital – It can be tough for small business owners to manage two separate accounts: business and personal. If you accidentally use your personal credit card to pay a business expense, such as office supplies, it would be considered a case of contributed capitalContributed CapitalContributed capital is the amount that shareholders have given to the company for buying their stake and is recorded in the books of accounts as the common stock and additional paid-in capital under the equity section of the company’s balance sheet. by the owner.
Why is it Important?
The business entity concept is extremely important for business owners because of several reasons which are described below.
- Increased accountability – Like we pointed out before, an obvious benefit is enabling a check on the owner’s actions whenever company funds are involved. Since any utilization of business capital for personal expenditure is considered an expense for the business, it increases the owner’s liability. It obligates the owner to be accountable for the loss of funds and requires them to repay.
- Separate Taxation – When it comes to tax filing, you will be thankful you kept your personal and business records separate. If you were to intertwine them, it would not only get cumbersome, it may cause disruptions to the cash flow and profitability.
- Measure Business Performance – The business entity concept is important because it also allows individuals to determine a specific business’s financial performance. Having separate accounting records will enable you to distinguish how well a company is performing. For example, investors look through a company’s financial reports to compare them with others in the industry to determine what business to invest in for best returns.
- Auditing – If the financial records are compromised or become mixed, it makes it nearly impossible for auditors to separate the information. The purpose of audits is to assure a business’s financial integrity and confirm all events that can affect a company’s performance.
- Competitor Comparisons – A critical part of any business model is to have the ability to compare its performance with the competitors. A key component of the SWOT analysis ( Strengths, Weaknesses, Opportunities, and Threats) comes from analyzing the competition and determining where your business fits in the industry. Through this technique, you can determine what is working for you and what needs to be changed. However, without proper accounting records, it will be a challenge to compare your business to others accurately.
- Keeps Multiple Businesses Separate – Just like how you would compare your business to the competition, you can compare your companies to one another accurately to determine how well they are performing.
- Shareholders/ Stakeholders – For those involved in the business, such as shareholders and stakeholders, accurate financial data is critical for making certain business decisions.
Limitations of Business Entity Concept
Although the concept is helpful in many situations, it also has its limitations. These include:
- Detailed Record Keeping – One of the limitations is the necessity to keep accurate data for accounting purposes. To maintain correct records, business owners must keep personal and business information separate. This can be especially challenging when trying to manage more than one business’s records.
- Legal or Accounting Regulation – There is a concept known as the “corporate veil” or “corporate shield” that applies to certain business entities, including
- Limited Liability CompaniesLimited Liability CompaniesLimited liability refers to that legal structure where the owners' or investors' personal assets are not at stake. Their accountability for business loss or debt doesn't exceed their capital investment in the company. It is applicable in partnership firms and limited liability companies.
The corporate veil shields the owners from liabilities pertaining to the business, like lawsuits. Legally, it’s important to understand this concept does not include basic partnerships or sole proprietorships. A corporate shield is a legal form of protection, whereas the business entity concept applies to recordkeeping and accounting practices.
- Personal Finances – Another limitation with the business entity concept is that individuals will not have the ability to view the owner’s personal finances or net worth as those records will be separate.
This has been a guide to Business Entity Concept and its definition. Here we discuss how it works along with the examples and why is it important. You may also have a look at the following articles to learn more –