What it means
Imagine a shop owner who pays for a family holiday from the shop's bank account. If the accounts simply recorded the payment as a business cost, profit would be understated and the picture of the shop would be wrong.
The entity concept says the holiday is a personal matter and should be recorded as money taken out by the owner, not as a cost of the shop. The principle applies to every form of business.
A sole trader is legally the same person as the business, but the accounts still treat the two as separate for record keeping. A company goes further, because it is a separate legal person that owns its assets and owes its debts in its own name.
This separation makes financial statements useful. Lenders, investors, tax authorities and managers want to see how the business has performed and what it owns and owes, without personal items mixed in.
The statements can then be compared from year to year and with other businesses. The concept also guides how groups are treated.
Each company in a group has its own accounts, but the group may also prepare consolidated accounts that treat the whole group as one reporting entity. In that case, the boundaries of the entity are drawn around the parent and its subsidiaries, and transactions inside the group are eliminated.
Problems arise when the boundary is ignored. Small business owners often mix personal and business spending, which makes the accounts unreliable, complicates tax returns and can cause difficulties if a lender or buyer looks closely.
A separate bank account and a clear record of any money the owner takes out or puts in solves most of these issues. Legal protection is a related but different matter.
A company's separate legal identity can protect the owners' personal assets from business debts, but this protection can be lost if the owner treats the business as a personal wallet. Careful separation of finances is therefore good for both accounting and legal reasons.
In practice
Real-world examples
Example 1
A freelance photographer buys a $2,000 camera lens for her business and a $600 television for her home, all on the same credit card. Her bookkeeper records the lens as a business asset and the television as a personal item, taking nothing for the television into the business accounts. Her profit is therefore not understated by a personal purchase.
Example 2
The owner of a family-owned company uses the company van for a weekend trip and pays for fuel from the business account. The accountant records the fuel as a drawing or a loan to the owner, not as a business expense. The records now show the true cost of running the company.
Example 3
A parent company lends $500,000 to its subsidiary. Each company records the loan in its own accounts, one as a receivable and the other as a payable. In the group consolidated accounts the loan is removed, since the group is a single reporting entity.
Think of it
The entity concept means the business is separate from its owners-keep personal stuff out of business books.
Case study
Seen in the real world
Windmill Bakery Partners is an illustrative, fictional bakery run by two partners who paid many personal bills from the business account. The accounts showed a profit of $18,000 for the year.
When the partners applied for a bank loan, the lender asked for an explanation of the large payments. The accountant reviewed the bank statements and found $42,000 of personal spending, including holidays and a family car, that should have been treated as the owners' withdrawals.
After removing those items, the real operating profit was $60,000, and the partners opened separate personal and business accounts. The illustrative lesson is that mixing personal and business money makes the business look weaker than it is and invites questions from lenders and tax authorities.
Watch out
Common mistakes
- Paying personal expenses from the business account and recording them as business costs.
- Assuming that a sole trader's business and personal finances do not need to be separated in the records.
- Forgetting to record money the owner puts into the business as capital or a loan.
Questions
People also ask
What is the entity concept in simple terms?
It means a business is treated as a separate unit for accounting, so only its own transactions are recorded in its books.
Does the entity concept mean the business is a separate legal person?
Not always, because a company is a separate legal person, but a sole trader is legally the same as the business and the separation applies only to the accounting records.
How does the entity concept affect group accounts?
It lets each company keep its own books while the group prepares consolidated statements that treat the parent and subsidiaries as one reporting entity.
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