The business entity or the economic entity assumption is an accounting principle that makes a legal distinction between the transactions carried out by a business and the transactions of the owner. It might also sometimes refer to the separation of different divisions in a company. Each unit maintains records of its operations and is responsible for its own transactions.
This does not only apply to the larger entities but also the smaller enterprises as well. A sole proprietor should keep his personal transactions separate to the business transactions. This assumption is also valid for business with multiple operations.
For example, a company might operate two independent businesses. It is expected that the company would present the financial statements of these two entities separately so that the true value of the company can be ascertained.
Importance of the Economic Entity Principle
The economic entity concept is important for a variety of reasons including the following:
- Business performance of various segments or divisions is measured separately.
- Audit becomes an easier process if separate financial records are maintained. If the records of different business units were intermingled, it would be a nightmare for the auditors to perform their evaluations.
- Each business unit is taxed separately.
- If a company violates this principle, comparing the financial performance of it with others in the industry would become difficult.
It is important to note the difference between a limited liability and the economic entity principle.
A limited liability is a type of legal structure for a business where the owner’s personal assets are not at stake in case the company makes losses and needs to pay its creditors. In other words, it creates a legal distinction between the owner and the business in a way similar to what the economic entity assumptions does.
However, there are few notable differences between the limited liability and the economic entity principle:
- First, the economic entity principle applies to all types of business entities including sole trader. The limited liability does not apply in the case of a sole trader.
- Second, Limited liability is a form of legal protections. Whereas, the economic entity principle achieves the separation of only the financial transactions of the owner and company.
Types of Business Entities
The most common types of economic entities are:
This is the simplest and basic form of a business entity. It is run by an individual for his own benefit and he does not have to share his profits with anyone else.
As per the economic entity assumption, the financial transactions of the owner and business are treated and accounted separately. This means that the owner’s personal assets and liabilities do not have to be included in the records of the company.
However, the sole proprietorship does suffer from having unlimited liability. This means that in the case of a company going bankrupt, the owner will be personally liable to pay the dues of the company from his personal assets. This is because the economic entity principle does not talk about the separation of any legal issues, it merely requires that the financial transactions of the owner and company are recorded separately.
A partnership can be of two types – general partnership and a limited liability partnership.
A general partnership is an agreement between two or more people of coming together to run a business. Each partner has a certain portion of capital invested whether it is in the form of money, skill or labor and then share in the profits and losses as per agreed upon terms. A general partnership is similar to a sole trader in terms of having unlimited liability, which means that the partners are personally liable for the debts of the company.
A limited liability partnership does away with this problem. The owners and the business entity are legally two separate entities. Therefore, if a business is bankrupt, the partners do not have to lose their personal possessions as in the case of a general unlimited liability partnership.
Limited Liability Company (LLC)
These are business entities that combine the pass-through taxation benefit of a sole trader with the limited liability benefit of a corporation. Due to the high flexibility in its structure, registering an LLC is a long and arduous process.
An article of incorporation is used to register and form a corporation. The shareholders have a limited liability and the employees enjoy tax free benefits such as health insurance. Corporations have a perpetual life, which means that ownership can be transferred to future generations by the existing shareholders.
The downside of a corporation is that they are subject to what is called “double taxation”. The first income tax is paid by the corporation on the profits it makes, and the second tax is paid by the shareholders on the dividends they receive. Another drawback of a corporation is the high cost it takes to set them up and that they are usually more regulated by the government.
Economic Entity Principle Examples
Here are some examples of when this concept can be violated:
- Tom uses his company’s credit card for personal expenses such as laundry and dining out. He argues that these expenses are business related as he wears clean clothes to his office and has a meal or two in between his meetings. As per the economic entity principle, these are not business expenses and should be accounted for as owner withdrawals or drawings from the company.
- Bob currently owns a donut shop and is considering buying a pizza shop that someone else has opened next door. After Bob goes through the acquiring process, he merges the financial of both entities into one single QuickBooks file. Bob is clearly in violation of the economic entity principle here as he has not treated both the donut shop and pizza shop as separate entities. As per the stated principle, the correct way would be to recognize that both entities are separate and their financial transactions should also be accounted for separately.