Business Entity Concept

Business entity concept requires a business to be treated as an entity different and distinct from its owners. It entails creation of separate books of accounts for each entity in which owners are an external party just like a creditor, employee, etc.

The business entity concept insulates a business from transactions of owners in their own personal capacities. This allows correct determination of profits earned, assets owned, taxes due, etc.

Businesses are organized either as a sole proprietorship, a partnership or a corporation. While the owners are quite distinct from the business in case of a corporation, they are one and the same in the case of sole proprietorship. In all forms business, the personal transactions of the owners are not mixed up with the transactions and accounts of the business. This is because doing so would make an effective analysis of an entity's financial performance and position impossible.

The business entity concept is useful not only in financial accounting but also in management accounting. Different departments may be considered business entities (say units) such that their performance is measured as if they are stand-alone entities. This enables analysis for the purpose of best allocation of capital.

Examples

A CPA has 3-room house he has rented for $3,000 per month. He has setup a single-member accounting practice and uses one room for the purpose of business. Under the business entity concept, only 1/3rd of the rent or $1,000 should be charged to business, because the other 2 rooms or $2,000 worth of rent is expended for personal purposes.

The CPA received $900 bill for utilities. He paid the whole amount using his business account. $600 is to be considered a withdrawal because only $300 (1/3rd) is related to business and the other $600 was for domestic purpose.

Assuming each public accounting business is required to pay $100 to a local association of CPAs each month. If the CPA pays that amount from a personal bank account, the amount shall be considered additional capital.

The same concept ought to be applied to any other common expenses.

by Obaidullah Jan, ACA, CFA and last modified on
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