The accounting theory known as the “business entity concept” mandates that enterprises be treated independently from their owners. This means that the financial statements of a business must show the business’s transactions and not the transactions of the owners. For example, if a sole proprietor buys a car for their business, the car would appear as asset on business’s balance sheet, not on the owner’s personal balance sheet. Similarly, if the business earns income, that income would be shown on the business’s income statement, not on the owner’s personal income statement.
The Business Entity Concept is important because it provides a clear distinction between the finances of a business and the finances of the owners. This distinction is important for both tax and legal purposes. The owners’ personal income is taxed separately from the organization’s income since the business and owners are considered as different entities for tax purposes. For legal purposes, the Business Entity Concept provides protection for the owners of a business in the event that the business is sued. If the business is sued, the owners’ personal assets are protected because they are not considered to be part of the business.
There are a few exceptions to the Business Entity Concept. The most common exception is the single ownership. Businesses that are owned and run by a single person are known as single ownership. The business and the owner’s personal finances are not regarded as independent entities as there is only one owner. This implies that the business’s debts and responsibilities are all personally owed by the lone proprietor. The collaboration is another exception to the Business Entity Concept. Businesses that are owned and run by two or more persons are called partnerships. Partnerships are not seen as being independent legal entities from their owners, similar to sole proprietorships. This implies that the business’s debts and responsibilities are all individually owed by the partners.
Examples
- A sole proprietor buys a car for their business. The car would mention as asset on the business’s balance sheet, not on the owner’s personal balance sheet.
- If the business earns income, that income would be shown on the business’s income statement, not on the owner’s personal income statement.
- The business and its owners are recognized as different legal entities, so their personal income is taxed separately from that of the business.
- In case the business is sued, the owners’ personal assets are protected because they are not considered to be part of the business.
- Single ownership is business that is look-after by an individual. Because there is only one owner, the business and the owner’s personal finances are not considered to be separate entities.
- Partnership or collaboration is a business that is owned and look-after by the group of people. Like sole proprietorships, partnerships are not considered to be separate entities from the owners.