The business entity concept, also known as the economic entity assumption, states that all business entities should be accounted for separately. In other words, businesses, related businesses, and the owners should be accounted for separately. Even though the tax law looks at a sole proprietorship and the owner as one entity, GAAP disagrees. The owner and the business are two separate entities and should be accounted for separately. The same goes for partnership and corporations. The partners and shareholders’ activities should be kept separate from the partnership and corporate transactions because they are separate economic entities.
The economic entity assumption does not always apply to a legal entity. For instance, a parent corporation and its subsidiaries can issue consolidated financial statements without contradicting the economic entity principle. A single company can also segregate business operations by department if the definition of “entity” is deemed to be within a company.
This business separation is useful for financial statement users. They can differentiate between the actual company activity and the ownership involvement. In other words, an investor can see if the business has good cash flow from it’s profitable operations or because the owner keeps funding the business with owner contributions.
Examples
– Mike, a partner in Big House Realty, LLC, often uses his company credit card for personal expenses like dry cleaning and new clothes. He insists that these are business expenses because he must wear new clothes in order to show houses. Unfortunately, these are not business expenses. Clothing is a personal expense and can’t be recorded in the company financial statements. This would violate the business entity concept. Instead, these transactions should be accounted for as an owner withdrawal.
– Assume Bob, a local landscaping business owner, decides to branch out and buy another existing business: a concrete company. This way his concrete company can pour footings and walkways and his landscaping business can landscape around them. Since Bob owns both companies personally, he thinks that he can combine both companies accounting records into one Quickbooks file. According to the business entity concept, both of these companies are separate entities and must be accounted for separately even though Bob is the owner of both companies. If Bob’s landscaping company had bought the concrete company, both companies would have merged and could be reported together.
– Jim, an owner of a pizza shop, decides to buy a new delivery car. Since the company was low on cash, Jim decided to pay for the car himself out of his personal bank account. Jim intends to add the car to the balance sheet of the pizza shop. The economic entity principle requires Jim and his company to keep activities separated, so the car must remain a personal vehicle unless Jim contributes it to the company or the company buys it from Jim personally.
