The business entity concept states that a business is an entity in itself and it should be treated as a separate person which is different from its owner. This assumption is of course be at variance with the legal position under which a certain form of business (such as sole proprietorship) and its owner may be considered the same. However, accounting records are based on the assumption that the business unit is a separate person. The only record that a business unit has in respect of its owner is the capital invested by its owner. Transactions related to the owner are not recorded in the books of accounts of the business nor are the owner’s personal assets and liabilities in the balance sheet of the business. Thus, when the owner invests an additional capital of say $5,000 into the business, the entry made in the business books is to record an increase in cash and an increase in capital both of $5,000. No entry is recorded in the books of business to record a reduction in cash in the personal bank account of the owner.
If the distinction between the owner and his business transactions, assets, and liabilities is not carefully maintained, the financial statements produced by the accounting records will not reflect the true and fair view of the business unit’s income or financial position.
As everyone accepts business entity concept, when people look at the income statement or balance sheet of a business unit, they automatically assume that these documents show strictly the income and financial position of the business unit only – not of its owner or owners.