Business Entity Concept – Definition
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. Business entity concept is also known as a separate entity concept and economic entity concept.
Under the Business entity concept, it is assumed that for the purpose of accounting practice business and owners are two separate entities. An accountant should be interested only in recording the affairs of business and not the personal affairs of the owners.
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 a 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 the 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.
What does a business entity mean?
The business entity consists of many persons and bodies. They include the owners—which are shareholders in the case of a corporation, partners in the case of partnership firms and proprietors in the case of proprietary concerns. While some businesses, particularly partnerships and proprietary concerns are managed by the owners, many business enterprises are managed by persons other than their owners. The hierarchy of managers may range from Chairman, Managing Director or Members of the Board of Directors right down to the sectional heads appointed to ‘manage specific operations of the enterprise. In addition to the managers, there are employees and workers who perform specific tasks under the overall supervision of the owners or managers.
A business exists primarily to produce goods and services at minimum cost and then sell them for a profit. However, the profits earned (or losses incurred) cannot be ascribed to any single person regardless of whether he is the owner or the manager or the employee of the business enterprise and, in the ultimate analysis, the results of the operations of a business must be related to the business entity itself. It is for this reason that the accounting process must be related to the operation of the business as a separate entity distinct from the persons within the organizations.
The concept of the business as a legal entity as distinct from its owners, has been well accepted in relation to corporations all distinct from its owners, has been well accepted in relation to corporations all over the world since the historical legal decision in England in the case of Salomon vs Salomon & Co (1897) A.C 22. Even though this legal concept has not been extended to partnership firms and proprietary businesses, it is necessary that, for purposes of accounting, all transactions should specifically relate to the operations of the business entity itself. Where transactions relating to persons or bodies with the business enterprise do arise, they are carefully separated so that the determination of the results of operations of the business entity itself is not in any way vitiated.
Example (Business Entity Concept)
If the owner of a business concern has spent $3,000 on paying rent of business shop and he has also spent $5,000 on education of his child, accountant will only record the rent paid by the owner as it is related with business and the later expenses will not be recorded as it comes in the personal matters of owner.
This concept is followed in all types of business organizations i.e. Sole-Proprietorship, Partnership and Joint Stock Company. But in Sole-Proprietorship & Partnership, it is only followed while recording in the books of accounts. Whereas this concept is fully followed in Joint Stock Company where the members and Company both have separate legal entities. This concept has made the analysis of accounting information very easy and result-oriented.