Business Entity Concept Definition Explanation Examples & Importance


Definition of Business Entity Concept

Business Entity Concept states that the business and the owner are two separate entities and accordingly must be treated separately. This concept is also called ‘Economic Entity Principle’ which explains that all the businesses, related businesses and the owners are separate entities and therefore these must be dealt with and accounted for separately. For example in a partnership firm, partners and the partnership/business are two separate entities. In case of corporations/companies, the company and its shareholders two separate entities. In case of sole proprietorship the business and the owner are two separate entities under accounting principle.

Explanation of Business Entity Concept

The business entity is defined as the undertakings which are under the control of a single management. The basic purpose of the financial record keeping of business entity is to measure that how successful or otherwise the business has been in terms of profit or loss. While recording and bookkeeping, accountants want to know that for whom they are accounting. This concept starts with the fact that business unit is separate entity with its owner(s) identity. An accountant is duty bound to keep the business and its activities quite separate from its owners at the time of bookkeeping. Owners’ personal activities should not be incorporated or merged with the business activities. Only those economic events performed by the owners which bear direct connection with business and affect the entity are recorded. When the separate entity concept is applied, the accounting records are kept only with viewpoint of business unit and not the owners. The accounting equation which captures the essence of business entity concept is:

Liability + Capital = Assets

This principle accommodates the concepts and principles of consolidation of financial statements. A parent company having subsidiaries companies can prepare and issue consolidated financial statements under relevant accounting standards without harming the concepts of separate entity principle. Moreover, this concept does not refrain a business unit from separating the departments by functions within the unit.

Why Entity Concept in Important

Business Entity Concept is imporant because if the business transactions are mixed up with other businesses or owners transitions, then there will be a question mark on accounting information usability.  

  1. Its helps in separate taxation both owner and business
  2. It helps to measure performance both in terms
  3. This concept helps to separately measure performance in terms of profitability and cash flows  
  4. It helps business to compare its financials with other in the industry

Examples of Business Entity Concept

1. Mr. Aaron is running a partnership firm along with other partners dealing in tourism services. Mr. Aaron who is also the managing partner has withdrawn $ 25,000/- for his daughter’s marriage. Upon the conclusion of wedding ceremony, the managing partner has furnished necessary invoices of expenses incurred and claimed that these expenses which are incurred in connection with the wedding should be treated as business expenses. Now in accordance with the Business Entity Concept and principle, these expenses are personal and bearing no connection with the business. Therefore, these shall not be recorded as business expenses but the same shall be shown as ‘partner’s drawings, deductible from his capital account.

2. Mr. Ashbel is the owner of a pharmaceutical unit which manufactures I.V solution. His son has registered a construction firm and started business. Mr. Ashbel wants that his accountant should merge these two businesses for bookkeeping purposes.  Since these two businesses are separate entities, their records would not be merged under the business entity principle. The accountant is required to keep records of these two separate entities separately.