Business Entity Concept: Definition

The business entity concept states that a business is an entity in itself. That is to say, it should be treated as a separate person, one that is distinct from its owner. The concept is also known as the separate entity concept and the economic entity concept.

Under the business entity concept, it is assumed that for the purpose of accounting practices, businesses and their owners are two separate entities. Accountants should only record the affairs of the business and not the personal affairs of the owners.

Business Entity Concept: Explanation

At the outset, it is worth noting that the assumptions underlying the business entity concept are, of course, at odds with the legal position under which a certain type of business (e.g., 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.

For example, when the owner invests additional capital of $5,000 into the business, the entry made in the books records an increase in cash and an increase in capital both of $5,000. No entry is made for the reduction of cash in the owner’s bank account.

If the distinction between the owner and their 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.

At present, the business entity concept is widely accepted. Thus, when people look at a firm’s income statement or balance sheet, they automatically assume that the documents strictly show the income and financial position of the business only, not of its owner(s).

What Does a Business Entity Mean?

A business entity consists of many persons and bodies. They include the owners, which are the shareholders (in the case of a corporation), partners (in the case of partnership firms), or 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 member 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 they are the owner, manager, or employee of the business. In the ultimate analysis, the results of the business operations must be related to the entity itself.

It is for this reason that the accounting process must be related to the operation of the business as a separate entity, one that is distinct from the persons interacting within organizations.

The concept of the business as a legal entity that is distinct from its owners has been largely accepted in the contemporary business landscape, but only for corporations.

In relation to corporations, the business entity concept first arose in the form of the historical legal decision in England in the case of Salomon vs Salomon & Co (1897) A.C 22.

The legal concept has not yet been extended to partnership firms and proprietary businesses. However, it is still necessary that, for purposes of accounting, all transactions should specifically relate to the operations of the business entity itself.

Wherever transactions relating to persons or bodies within 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 obstructed.

Example

If the owner of a business spends $3,000 on paying rent for her shop, along with $5,000 on school fees for their child, the accountant will only record the rent payment. This is because it is related to the business, whereas school fees are personal matters of the owner.

This concept is followed in all types of business organizations, including sole proprietorships, partnerships, and joint-stock companies. In sole proprietorships and partnerships, it is only followed when recording in the books of accounts.

By contrast, in joint-stock companies, the concept is fully followed. In particular, members and the Company both have separate legal entities. This concept has made the analysis of accounting information very easy and results-oriented.

Frequently Asked Questions

How is the business entity different from its owners?

A business entity consists of all those who are involved in a business activity. It includes the owners, managers, and workers or employees that contribute to making a profit for the company. Although the owners have a very important role as members owning a part of a business entity, their activities generally do not contribute to making profit and loss. Therefore, those activities are not relevant for the purpose of accounting information about the business itself.

What is a legal entity?

A legal entity or organization can be generally described as an independent group that has certain rights and responsibilities different from those of its members such as owning assets, entering into contracts, and incurring liabilities.

What is a separate legal entity?

A separate legal entity is one that has rights and responsibilities different from its members such as owning assets, entering into contracts, and incurring liabilities.

What is the relationship between owners and business entities?

The relationship of owners to business entities consists of their rights in, and claims on, the assets of the business entity. Owners' rights are limited to their proportional share in the assets of a business. Owners have no claim or liability for any debts or liabilities that may exist within the organization.

What is the relationship between owners and business entities?

The purpose of adopting the concept of business entity is to maintain a clear distinction between transactions that are related to the business operations of the entity and those that are not.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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