What is the accounting principle that states companies and owners should be account for separately?

Small business accounting can be a complex practice, but there are several general accounting principles that help business owners structure their accounting procedures and maintain clear and accurate books. It is important that businesses adhere to the practice of business entity assumption so that they are not only protected legally, but so their company's financial picture is also clearly portrayed.

Business Entity Assumption Defined

Business entity assumption, sometimes referred to as separate entity assumption or the economic entity concept, is an accounting principal that states that the financial records of any business must be kept separate from those of its owners or any other business. All income derived from the company's operation must be recorded as earnings and all expenses must be those belonging solely to the business. Any personal expenses of the owner should not be passed on to the company. This strict adherence to separation allows the business to be evaluated for profitability and tax purposes based on accurate financial data rather than a muddled mix of personal and business finances. It is also applied to all businesses even if legally a business and its owner as viewed as the same entity.

Legal vs. Accounting Separation

Businesses exist in a variety of forms and each structure has its own legal and taxing regulations applied to it. Many small businesses are considered pass-through entities, where the business is not taxed on its income, but all income is "passed through" to the owners and they are taxed on the amount of income the business has earned. Examples of pass-through entities include sole proprietorships, S corporations and limited liability companies (LLC). However in a sole proprietorship, the business and the individual owner are viewed legally as one and the same. All the liabilities of the business, financial and legal, become the liabilities of the owner. Still, even though viewed legally as the same, sole proprietors must maintain and report their personal and business finances separately.

Accurate Recording Keeping Required

One of the disadvantages of the business entity concept in accounting is that company owners must be very careful to keep detailed and accurate financial records, particularly of their expenditures. All personal and business expenses must be kept separate. This means that procedures should be set in place to ensure that accounting records reflect accurate expense amounts based on the purpose or percentage of use. For example, if a business owner purchases gas for a car personally owned by him using a personal credit card, but uses that gas and car for business travel, then the owner should be reimbursed for those expenses using the standard mileage rate allowed by the Internal Revenue Service (IRS). However, if the business owner takes the company owned car and uses his business credit card to purchase gas while on a week-long vacation, those expenditures should not be recorded as business expenses in the company financial records but should be taken as a personal withdrawal.

Managing Corporate Divisions or Multiple Businesses 

Another business entity example that requires separate accounting is when distinct divisions exist within a company or an individual owns more than one business. If your business grows, you may have the opportunity to expand beyond the scope of your current operations. You may choose to set up a separate division within the company to handle this new business opportunity. In order to track the financial health and operations of this segment of the company, it is a good idea to record all the income and expenses separately from the other part of the company. This can be done by utilizing "classes" within accounting software such as QuickBooks. For tax and legal purposes, the division still falls under the auspices of the main company, but the separate accounting will enable you to evaluate the its financial health independently.

Similarly, if a business owner runs more than one company, separate entity assumption should be maintained for each business. Although the owner is the same, the companies may be very different in scope and size, and all transactions should be recorded separately.

* Choose the Correct answer

1. The personal assets of the owner of a company will not appear on the company's balance sheet because of which principle/guideline?

___________ Cost

____________ Economic Entity

___________ Monetary Unit

* The Right answer is Economic Entity .

• because The owner's assets are not shown on the balance sheet of the business. This is true even if the business is a sole proprietorship.
• while The cost principle is associated with the carrying amounts of the business assets.
• The monetary unit involves the expression of amounts in dollars and the assumption that the dollar's purchasing power does not change (no inflation).

2. Which principle/guideline requires a company's balance sheet to report its land at the amount the company paid to acquire the land, even if the land could be sold today at a significantly higher amount?

__________ Cost

____________ Economic Entity

___________ Monetary Unit

* The Right answer is Cost

• The cost principle requires the accountant to show assets at cost and expenses at cost rather than at higher amounts. Accountants are not allowed to recognize gains from merely holding the land. To be able to recognize a gain on the land, the company would have to sell the land.
• Economic Entity assumption involves keeping the owner's personal transactions separate from the business transactions.
• The monetary unit assumption is that the dollar is stable over time—no inflation.

3. Which principle/guideline allows a company to ignore the change in the purchasing power of the dollar over time?

_________ Cost

_________ Economic Entity

__________ Monetary Unit

* The Right answer is The monetary unit that assumption that the dollar is stable over time—no inflation.

4. Which principle/guideline requires the company's financial statements to have footnotes containing information that is important to users of the financial statements?

____________ Conservatism

_________ Economic Entity

___________ Full Disclosure

* The right answer is The full disclosure principle that requires businesses to disclose information that is relevant to the decisions of investors and creditors.

• Conservatism involves choosing between acceptable alternatives. In other words conservatism is used to break a tie between two acceptable choices of how to account for something. It is also associated with recognizing losses but not gains for certain situations.

5. Which principle/guideline justifies a company violating an accounting principle because the amounts are immaterial?

_________ Conservatism

__________ Full Disclosure

_________ Materiality

* The right answer is Materiality

• When an amount is so small/immaterial an accountant may decide to ignore an accounting principle.

For example, a large company might purchase a $300 digital camera to be used for the next five years. The matching principle would call for an expense (depreciation) of $60 per year for five years. Most accountants would violate the matching principle and expense the entire $300 in the year it is acquired. The rationale is that the decision makers would not be misled by the small differences of $240 in the year purchased and $60 per year in each of the following four years.

6. Which principle/guideline is associated with the assumption that the company will continue on long enough to carry out its objectives and commitments?

__________ Economic Entity

________ Going Concern

________ Time Period

* The right answer is Going Concern

• while The time period assumption (also known as periodicity) is the assumption that the ongoing business activity can be segregated into time periods of a year, a month, a week, etc.

7. A very large corporation's financial statements have the dollar amounts rounded to the nearest $1,000. Which accounting principle/guideline justifies not reporting the amounts to the penny?

________ Full Disclosure

_______ Materiality

_______ Monetary Unit

* The right answer is Materiality As long as the digits omitted are small in relation to the true amounts, companies will round numbers so as to emphasize the relevant digits. The rationale is that no one will be misled by the omission of the insignificant digits.

• while In the U.S. the monetary unit is associated with the reporting of all items in U. S. dollars and that the U. S. dollar's purchasing power does not change over time.

8. Accountants might recognize losses but not gains in certain situations. For example, the company might write-down the cost of inventory, but will not write-up the cost of inventory. Which principle/guideline is associated with this action?

______ Conservatism Right!

__________ Materiality

_______ Monetary Unit .

* The Right answer is Conservatism that involves choosing between acceptable alternatives. In other words conservatism is used to break a tie between two acceptable choices of how to account for something. It is also associated with recognizing losses but not gains for certain situations.

9. Which principle/guideline directs a company to show all the expenses related to its revenues of a specified period even if the expenses were not paid in that period?

_________ Cost

________ Matching

________ Monetary Unit

* The Right answer is Matching.

• while The cost principle requires the accountant to show assets and expenses at cost rather than at higher amounts.

10. When the accountant has to choose between two acceptable alternatives, the accountant should select the alternative that will report less profit, less asset amount, or a greater liability amount. This is based upon which principle/guideline?

_________ Conservatism

_________ Cost

_______ Materiality

* The Right answer is Conservatism is used in order to 'break a tie'. Accountants should strive to be objective and to use conservatism when doubt exists between two options.

• while the Cost involves recording transactions at their cash value at the time of the transaction.
• Materiality involves insignificant amounts and the accounting for those amounts.

11. Public utilities' balance sheets list the plant assets before the current assets. This is acceptable under which accounting principle/guideline?

__________ Conservatism

_________ Cost

_________ Industry Practices

* The Right answer is Industry Practices.

• Certain industries (usually those that are regulated by the government) have unique reporting requirements that are followed on the financial statements as well as the reports to the government.

12. A large company purchases a $250 digital camera and expenses it immediately instead of recording it as an asset and depreciating it over its useful life. This practice may be acceptable because of which principle/guideline?

________ Cost

_______ Matching

_______ Materiality

* The Right answer is Materiality Because this is a large company, $250 is considered to be an insignificant amount. Hence if the company depreciates the camera at $50 per year for five years or expenses $250 in the year it is purchased, an investor or lender would not be misled by the additional expense of $200 per year in the first year and the $50 difference in the next four years.

13. A corporation pays its annual property tax bill of approximately $12,000 in one payment each December 28. During the year, the corporation's monthly income statements report Property Tax Expense of $1,000. This is an example of which accounting principle/guideline?

_______ Conservatism

_______Matching

______ Monetary Unit

* The Right answer is matching principle that requires the company to match 1/12 of the annual property tax to each month when revenues are earned as a result of the property.

14. A company sold merchandise of $8,000 to a customer in December. The company's sales terms require the customer to pay the company in 30 days. The company's income statement reported the sale in December. This is proper under which accounting principle/guideline?

_________ Full Disclosure

________ Monetary Unit

________ Revenue Recognition

* The right answer is revenue recognition principle that requires that revenue be reported when revenue is earned (when goods are sold or services are provided) and not at the time when payment is received.

15. Accrual accounting is based on this principle/guideline.

__________ Cost

__________ Full Disclosure

_________ Matching

* The right answer is The matching principle that requires that expenses be matched to the:

-Related revenues or

-to the accounting period when the expenses are incurred.

When the expenses are paid for is not relevant.

16. The creative chief executive of a corporation who is personally responsible for numerous inventions and innovations is not reported as an asset on the corporation's balance sheet. The accounting principle/guideline that prevents the corporation for reporting this person as an asset is

________ Conservatism

________Cost

______ Going Concerns

* The Right answer is The cost principle

• That requires that assets and other transactions be recorded at cost. The chief executive was not purchased at a cost and therefore is not reported as an asset on the corporation's balance sheet.
• The monetary unit assumption is also another reason why the executive is not recorded—we do not know how to measure the executive in U.S. dollars.

17. An asset with a cost of $120,000 is depreciated over its useful life of 10 years rather than expensing the entire amount when it is purchased. This complies with which principle/guideline?

_______ Cost

_______ Full Disclosure

_______ Matching

* The Right answer is The matching principle

• that requires that expenses be matched to the related revenues or to the accounting period when the expenses are incurred. When the expenses are paid for is not relevant.

18. Near the end of the current year, a company required a customer to pay $200,000 as a deposit for work that is to begin in the following year. At the end of the current year the company reported the $200,000 as a liability on its balance sheet. Which accounting principle/guideline prevented the company from reporting the $200,000 on its income statement for the current year?

___________ Going concern

____________ Materiality

___________ Revenue Recognition Right!

* The Right answer is Revenue recognition principle

• That requires that revenues be recognized when they are earned, not when the cash is received.

19. A retailer wishes to report its merchandise inventory on its balance sheet at its retail value. This would violate which accounting principle/guideline?

________ Cost

________ Full Disclosure

________ Monetary Unit

* The Right answer is The cost principle

• that requires that assets be recorded at their cost at the time they are acquired. The cost principle prohibits increasing the cost of items in inventory before an item is sold.

20. A company borrowed $100,000 in December and will make its only payment for interest when the note comes due six months later. The total interest for the six months will be $3,600. On the December income statement the accountant reported Interest Expense of $600. This action was the result of which accounting principle/guideline?

________ Cost

_______ Matching

_______ Revenue Recognition Wrong.

* The Right answer is The matching principle that requires that expenses be matched with the related revenues or to the appropriate period of time.

In this case the company is incurring interest expense every minute that it has the loan.

For one month's use of the money, the company has Interest Expense of $600 and it needs to be reported on the December income statement in order to be in compliance with the matching principle and the accrual basis of accounting.

* Let's Guess the proper word

1. General guidelines. __________

* PRINCIPLES

2. The __________ unit assumption means transactions of U.S. companies are reported in dollars.

* MONETARY

3. Adjusting entries help to achieve the ____________ principle.

* MATCHING

4. The cost principle is often described as the __________ cost principle.

* HISTORICAL

5. __________ practices allows the format of a public utility's balance sheet to be different from that of a manufacturer.

* INDUSTRY

6. The concept of _________________ allows for the violation of an accounting principle when the amounts are insignificant.

* MATERIALITY

7. The __________ entity assumption results in business transactions being kept separate from a sole proprietor's personal transactions.

* ECONOMIC

8. In cases of uncertainty, less profit is reported under this concept.

* CONSERVATISM

9. Full __________ is achieved through the notes to the financial statements.

* DISCLOSURE

10. This assumption justifies quarterly financial statements.

* PERIODICITY

11. Defined as the cash or cash equivalent amount at the time of a transaction.

* COST

12. Accrual accounting is related to this principle.

* MATCHING

13. Results in the reporting of contingent losses, but not contingent gains.

* CONSERVATISM

14. Permits the immediate expensing of insignificant assets.

* MATERIALITY

15. FASB is the acronym for _____________ Accounting Standards Board.

* FINANCIAL

16. The __________ concern assumption is that an enterprise will continue on long enough to carry out its objectives and commitments.

* GOING

17. Communicating the significant accounting policies in the first note to the financial statements is related to the full ______________ principle.

* DISCLOSURE

18. The U.S. government agency with authority over the reporting requirements of corporations whose stock is publicly traded in the U.S. is the Securities and ______________ Commission.

* EXCHANGE

19. Under the __________-basis of accounting, revenues are reported on the income statement in the period in which they are earned.

* ACCRUAL

20. Part of the _______________ unit assumption is that the U.S. dollar retains its purchasing power over time.

* MONETARY

Reference :

https://www.accountingcoach.com.

Which concept of accounting tells that business is separate from owner?

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