written by | August 9, 2022

Business Entity Concept: Definition and Importance

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Table of Content


The business entity concept says that a company is nothing but an entity, meaning it must be dealt with as a separate person, different from its owner. The business entity concept in accounting is also recognised as the Economic Entity Concept or the Separate Entity Concept. In the business entity concept. It is accepted that companies and their proprietors are two distinct entities for meeting the accounting practices objective. 

Did you know? Without the business entity concept, the records of different entities may get mixed, making it impossible to ascertain the economic growth of a business.

What Is the Business Entity Concept? 

An accountant should only document the company's transactions, not the business owner's personal transactions. 

The only document that a business should have in regards to its owners is the capital contributed by the owners. Personal transactions are not documented in the account books of the company. It’s because the company is not the owner’s personal asset and affects the company's balance sheet if included.

The Business Entity Concept in Accounting

This concept takes into account many individuals and groups. They include the owners, who are the shareholders if it is a company, partners if it is a partnership firm or the proprietor if it is a proprietary business.

While proprietors and active partners govern proprietary concerns and partnerships, many companies are run by those appointed by the shareholders or take care of the day-to-day activities. 

Also read: Liabilities in Accounting - What are Accounting Liabilities? Explained in Detail

The management structure might run from the Chairman, the Board of Directors, and Managing Director to the section bosses appointed to supervise specific business undertakings.

Besides the administrators, some workers and employees execute specific tasks as required.

Definition of Business Entity Concept

The business entity concept states that a business is separate from its owner. Therefore, the two must be dealt with as distinct entities when documenting transactions. Hence, all business transactions (income, expenses, equity, assets, and liabilities) must be kept free from the owner’s account to guarantee accurate accounting documents.

The business entity concept suggests business owners must keep personal and business affairs independent. It can help in making accurate accounting documents and guarantee simpler tax filings.

This idea allows people to evaluate their financial accomplishments accurately, inside the business or otherwise.

It is more difficult to define business entity concept than the corporate veil. It is regarded as an accounting technique rather than a legal practice.

How Does a Business Work?

The business entity concept meaning must be applied to every kind of industry, sole proprietorship, partnership, and company in order to maintain financial quality for those participating in the business. The objective of the theory is to guarantee the business's financial statements. It helps evaluate the company’s objectives. It also enables shareholders and other people to calculate its financial position and achievements.

The meaning of business entity concept is to prevent business and personal expenditures from mixing up. Any money shifting to the company or from the company should be documented in distinct accounting transactions to avoid complications.

Business Entity Concept- Examples

The owner’s drawings are a business entity concept example.

Let us say, for instance, you are the owner of a business, and you take money from the business to reimburse for your kid’s education. Such a withdrawal is not an expenditure for the business as it is the use of money from the business to fund a personal expenditure. The transaction should be marked as a proprietor’s drawings to imply that it is for the owner's private usage. However, It doesn’t include reimbursing proprietors or owners for business-related expenses and their salaries. 

Significance of the Business Entity Concept

A business entity concept in accounting is very important for company owners for numerous reasons mentioned below:

Increased responsibility

As stated before, an apparent benefit is that if business accounts are used for personal expenses, an inspection of the books will reveal their nature. Since any usage of business equity for personal expense is not a business expenditure, the owners must ensure the separation stays intact. 

Also read: Understand Accounting Ratios – Overview, Meaning, Types and Formulas

Separate Taxes

Regarding tax filings, you must keep your business and personal filings separate. It will make the overall tax planning and management of your business better.

Monitor Company Performance

The business entity concept meaning is essential because it encourages individuals to specify the organisation's financial achievements. For instance, investors look through a business’s financial documents to correlate them with other businesses to specify what a company can capitalise on to get favourable returns. Having separate accounting distinct from the owners will help them understand how the business performs. 

Auditing 

When the monetary records are changed, it makes no sense for auditors to separate the data. The objective of an audit is to encourage a business’s financial integrity and verify all incidents affecting an organisation’s achievement.

Competition Comparisons

Through business entity concept strategy, you can find out what is actually working for your business and what needs to be altered. Nevertheless, it would be challenging to distinguish your company from others without proper accounting documents.

Keeps Several Businesses Independent 

Just as you would compare your company to the competitor, you can accurately distinguish your businesses from each other to find how well they are performing. 

Stakeholders and Shareholders

For those involved in the company, such as shareholders and other stakeholders, accurate financial data is crucial for making specific business judgements. 

Also read: Goodwill in Accounting - Learn About Types of Goodwill and How to Calculate Goodwill

Example 

A business entity concept example is when a business proprietor pays ₹3,000 for the shop rent and ₹5,000 for the child's school fee. The accountant would only document the rent expense. It is because the school expenses are personal expenses of the proprietor.

This concept is used in all kinds of business associations, including sole proprietorships, partnerships, and companies. 

Conclusion

Businesses exist mainly to generate services and goods at minimum expenditure and then trade them for profits. However, the profits received or any losses incurred do not go to any isolated person, irrespective of whether they are an owner, executive, or worker of the company. 

For this purpose, the business entity concept in accounting must be connected to the company as a separate entity. Therefore a company as a lawful entity is different from its proprietors. It is essential that all transactions must specifically refer to the undertakings of the company itself. 
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FAQs

Q: Is there a relationship between businesses and owners?

Ans:

The objective of the business entity concept is to maintain a clear distinction between agreements that belong to the company and those that are personal to an owner. Therefore, the owners and the businesses are separate entities.

Q: What are separate legal entities?

Ans:

Separate legal entities are corporations that have certain rights and obligations similar to a business such as the power to sue, be sued, own assets, etc.

Q: What are legal entities?

Ans:

A legal organisation or entity may be normally characterised as an autonomous organisation that has distinct rights and obligations from its entities, such as owning assets, making agreements, and incurring damages.

Q: How is a business any different from its holders?

Ans:

A business entity comprises all people who are involved in employment activity. It comprises the owners, workers, employees or managers that participate in making revenue for the business. Although the shareholders have an extremely significant role as partners owning a fraction of a company entity, their personal actions have nothing to do with the business. Thus, those actions are not related to the objective of accounting data about the company.

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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.