Business Entity Concept – Definition, Explanation, Examples
The business entity concept is an important term in accounting. Without this concept, accountants will find it difficult to properly separate business expenses from business owners to get accurate bookkeeping records.
This article will teach the business entity concept to help you accurately account for your business profits.
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What is the Business Entity Concept?
The business entity concept states that your business transactions be recorded as a separate entity from the personal affairs and financial decisions of the business owner or other businesses. It is an essential principle of the financial accounting concept.
For the business entity concept to be fully functional, corporate transactions of the business enterprise need to be separated via separate accounting records from the personal expenses or any other entity owned by the owner, such as assets and liabilities.
Without the business entity concept, it becomes challenging to determine the financial position of your business. Analysis of accounting information becomes easier and more result-driven with the business entity concept in use.
Otherwise referred to as the economic entity assumption, the business entity concept is particularly applicable to all business organizations, irrespective of whether a prior law adequately recognizes a business and its subsequent owner as separate entities.
Importance of Business Entity Concept in Accounting
The business or economic entity concept benefits accounting by structuring companies and corporations for better business performance.
Using separate accounts in recording transactions related to your business from other entities, related companies, and personal use positions your business for better financial performance.
Some of the importance of using the business entity concept for your accounting needs include:
1. Increased Accountability
The business entity can be an adequate check and balance mechanism to track owners' actions concerning the company's funds.
Using the business capital for personal expenditure is considered a personal expense and increases the owner's liability.
2. Separate Taxation
Ensuring your personal and business transactions are recorded separately ensures you are taxed separately.
With the separate entity concept, you are shielded from the risk of disrupted cash flows due to the overwhelming cost of paying all your taxes together.
3. Measures Business Performance
With the business entity concept, you can adequately measure specific business financial performance and KPIs, highlighting how well your business has performed over time in terms of profitability and money made.
Having a mixed and joint financial record of your business and personal expenses makes it relatively difficult for external auditors to separate these two transactions from each other.
With the business entity concept in play, there is a clear distinction between related businesses and your personal life.
5. Ensures Multiple Businesses are Kept Separate
Being able to compare your business model against the performance of a known industry giant is a critical criterion of any successful legal entity. You have a bearing on where your business stands in terms of performance.
Apart from competitors, you can compare companies to other business entities to determine their respective performance levels.
The business entity concept has a wide range of use across many industry sectors, particularly accounting.
Consider a business organization that sets aside a sum of $10,000 to be distributed to its shareholders.
Under the business entity concept, there is a reduction of $10,000 in equity highlighted in the organization's accounting records and a corresponding $10,000 of taxable income issued to the shareholders.
Another example is the case of the owner of a company using his finance to acquire an office building. The owner then rents out space to the company for $50,000 per month.
With the business entity concept in use, the rent expenditure being a valid expense of the company is recorded as part of the owner's taxable income.
A company owner rents a building complex of 2 standard halls for $10,000 per month. The owner then decides to use one of the halls for strictly business use and the other hall for his personal use.
With the business entity concept in play, only the rent paid for the halls designated for business is considered a business expense.
When business owners lend money from their coffers to their companies, it would be recorded as a liability for such a company under the business entity concept. It would be required to be paid back to the owner in full.
Another example is a business owner with two different credit cards, one for his business and the other solely for personal use.
If he then uses his credit card meant for personal use to pay for expenses that are business related, under the business entity concept, the business owner's payment made via his personal credit card would be regarded as additional capital being pumped into the business.
Types of Business Entities
Business entities exist in different types and forms depending on specific characteristics that distinguish them from one another.
Some common types of business entities include:
1. Sole Proprietorship
Sole proprietorships involve only one individual at the helm of all business operations and are the sole receiver of the outcome of the business, be it profit or loss.
With the business entity concept in play, the financial transactions of the business owner and business are treated as two separate entities without including the personal assets and liabilities of the owner in the company records.
One of the disadvantages of this type of business entity is that the sole proprietor of the business is not immune from liability as they are personally liable to pay back all required dues from his assets if the company goes bankrupt.
With the business entity concept not providing cover in the event of legal issues, the owner is left to fend for himself when such a situation arises.
Generally, a partnership can be either a general partnership, limited or a limited liability partnership, with the general partnership being the most popular and widely used of the two.
A general partnership involves an agreement between two or more people, each contributing a significant amount of the capital required to run the business.
If the company's development goes bankrupt, the partners are liable to pay back their assets. The outcome, be it profit or loss, is shared among partners.
A limited liability partnership, on the other hand, is different from a general partnership in the sense that the owners and the business entity are two separate entities and are not at risk of losing their personal belongings if the business goes bankrupt.
3. Limited Liability Company (LLC)
Limited liability companies are business entities that use the benefits sole proprietors get from taxation with the limited liability of a limited liability partnership. In other words, it uses the best features of these two business entity types.
To successfully form and register a corporation, you are required to file for an article of incorporation.
With a corporation, shareholders enjoy limited liability while the employees enjoy free tax benefits initiatives paid by the profits generated by the corporation. There is flexibility in the transfer of ownership among corporations as it runs on a perpetual life system.
The main disadvantage of a corporation is that it is subject to double taxation, as both the profits made by the corporation and the dividends received by shareholders are subjected to tax.