Business Entity Concept

Definition

In accounting business entity concept implies that business is distinct and separate from its owners i.e. business and its activities are independent of its owner and their respective activities.

Explanation

Business entity concept is also called separate entity concept, separate economic entity concept.

Technically for accounting purposes this concept has following implications:

  1. Assets and liabilities of business are separate from assets and liabilities of its owner
  2. Income and expenses of business are separate from income and expenses of its owner
  3. Transactions related to business activities must be recorded separately.
  4. Decisions dealings of owners in their personal capacity has no burden on business and same applies for business. Agreements and contracts of owners in their personal capacity are not agreements and contracts of business.
  5. If a single transaction for both business and owner is carried out, the effect should be divided between business and owner using appropriate basis and only relevant share should be recorded in business’ books of accounts.

Irrespective of entity’s type i.e. sole proprietorship, partnership or company, business entity concept is upheld and applied similarly i.e. business transactions are separate from its owner’s activities.

Examples

  1. Mr. P owns two sole trader entities Popdew and Pepperseed. Mr P’s pay for his children education out of Popdew bank account whereas expenses for recent vacations was paid out of Pepperseed credit card.
    Accounting treatment:
    Payment by Popdew is non-business expenditures therefore considered drawing of capital by Mr. P. and should be deducted from equity in Popdew’s financial statement.
    As credit card is funded by Pepperseed and is used to pay non-business expense, again it is considered withdrawal of capital by Mr. P and treated as reduction in equity in Pepperseed’s accounting books
  2. Mr. P has lent 10,000 at 5% interest rate to Popdew. However, repayments to Mr. P are only for principal amounts and interest portion is not paid.
    Accounting treatment:
    Money lent will be recorded as Popdew’s liability and not as capital. Interest charged will be recorded as business expense and added to capital/equity of the business as interest amount is not paid/withdrawn.
  3. Pepperseed gives free carriage to its customers which is carried out by renting a vehicle for each customer. As business is growing Mr. P bought a vehicle using Popdew’s cash to for Pepperseed’s delivery purposes. As Mr. P owns both businesses and same for him, although Popdew bought the vehicle, he is of the opinion that Pepperseed can recognize vehicle as its asset as it will be used solely by Pepperseed.
    Accounting treatment:
    Popdew and Pepperseed, although under single ownership, does not amount to single entity. Both are separate and distinct. Assets of Popdew cannot be mixed and attached to Pepperseed.
    Purchase of vehicle can have following treatments but not limited to:

    1. Treat payment by Popdew as drawings and vehicle given to Pepperseed as capital.
    2. Payment by Popdew is a direct investment in Pepperseed and thus now an equity holder. This will create long term asset in Popdew’s books and capital addition in Pepperseed’s books.
    3. Vehicle is lent by Popdew to Pepperseed and thus recorded as asset in Popdew’s account and liability for Pepperseed’s books of accounts.
    4. Vehicle is given by Popdew to Pepperseed on lease. This will require application of substance over form concept.

Separate entity vs Separate legal entity

Separate entity concept however, must not be confused with separate legal entity concept as application of an accounting concept does overrule legal concepts that varies from one situation and jurisdiction to another.

Legally, under many jurisdiction, sole traders and partnerships are not separate from its owners because owners have unlimited liability. Having unlimited liability means if business entity fails to pay its liabilities through its assets and resources, owners’ assets and resources will be annexed to pay off liabilities. Due to this reason¬†assets and liabilities of business and owners are attached to each other for such types of businesses. And in this case provisions of law overrules the accounting concept.