What is the accounting concept that requires every business to be accounted for separately from other business entities?

Definition: The business entity concept is an accounting principle that requires a business to be accounted for and treated as a separate entity from its owners. In other words, GAAP realizes that a business and its owner are two different things. The business is the entity that attempts to generate profits from its operations; where as, an owner is someone who attempts to generate returns on his or her investment in the business.

Despite how the tax code treats different forms of business, GAAP requires that companies must be accounted for as a separate entity from their owners. There are three different forms of business entities: sole proprietorship, partnership, and corporation.

A sole proprietorship is the simplest business structure and doesn’t require any legal forms in order to create. You can think of a sole prop as a one-man shop. There is only one owner who is unlimitedly liable for all the company’s actions.

A partnership is an organization of at least two partners. This too can be formed without any legal paper work. Different forms of partnerships like LLCs and LLPs have limited liability protection.

A corporation is the most popular form of business because it protects the owners with limited liability.

Example

All of these types of entities must be accounted for separately from their owners. You can think of the business entity concept like a bank account. The business has its own checking account and the owners have their own personal accounts. The business doesn’t use the owners’ accounts to purchase supplies and the owner doesn’t use the business accounts to may his mortgage. The owners and the company must maintain separate accounts at all times.

If the company needs money, the owners can either lend money to the company or invest more money by purchases more stock or a great ownership percentage.

The business entity concept, also known as the economic entity assumption, states that all business entities should be accounted for separately. In other words, businesses, related businesses, and the owners should be accounted for separately. Even though the tax law looks at a sole proprietorship and the owner as one entity, GAAP disagrees. The owner and the business are two separate entities and should be accounted for separately. The same goes for partnership and corporations. The partners and shareholders’ activities should be kept separate from the partnership and corporate transactions because they are separate economic entities.

The economic entity assumption does not always apply to a legal entity. For instance, a parent corporation and its subsidiaries can issue consolidated financial statements without contradicting the economic entity principle. A single company can also segregate business operations by department if the definition of “entity” is deemed to be within a company.

This business separation is useful for financial statement users. They can differentiate between the actual company activity and the ownership involvement. In other words, an investor can see if the business has good cash flow from it’s profitable operations or because the owner keeps funding the business with owner contributions.

– Mike, a partner in Big House Realty, LLC, often uses his company credit card for personal expenses like dry cleaning and new clothes. He insists that these are business expenses because he must wear new clothes in order to show houses. Unfortunately, these are not business expenses. Clothing is a personal expense and can’t be recorded in the company financial statements. This would violate the business entity concept. Instead, these transactions should be accounted for as an owner withdrawal.

– Assume Bob, a local landscaping business owner, decides to branch out and buy another existing business: a concrete company. This way his concrete company can pour footings and walkways and his landscaping business can landscape around them. Since Bob owns both companies personally, he thinks that he can combine both companies accounting records into one Quickbooks file. According to the business entity concept, both of these companies are separate entities and must be accounted for separately even though Bob is the owner of both companies. If Bob’s landscaping company had bought the concrete company, both companies would have merged and could be reported together.

– Jim, an owner of a pizza shop, decides to buy a new delivery car. Since the company was low on cash, Jim decided to pay for the car himself out of his personal bank account. Jim intends to add the car to the balance sheet of the pizza shop. The economic entity principle requires Jim and his company to keep activities separated, so the car must remain a personal vehicle unless Jim contributes it to the company or the company buys it from Jim personally.