Accounts are maintained for business entities, rather than the people who own, operate, or are associated with the business. The business entity concept assumes that a business enterprise is separate and distinct from the owner or investor.
For example, Mr. A is the sole owner of Bed Linens Online, a sole proprietorship. Mr. A withdraws $100.00 from the business. When preparing the financial accounts of the business, we must record the effect of this transaction on the Bed Linens Online accounts.
In this transaction, Mr. A exchanges $100 of owner’s equity for $100 in cash. Mr. A is no better or worse than before. We have seen that Mr. A is doing just as well after this transaction as before. What about the business? He now has $100 less in assets.
Obviously, transactions like this can affect the owner in one way and the business in another. However, Bed Linens Online financial accounts will only report the effect the transaction has on the business.
The fact that accounts are kept for business entities as opposed to the persons associated with those entities is called the business entity concept.
A business can be organized under any of several legal forms, such as corporation, partnership, or unincorporated ownership. The concept of business entity applies regardless of legal status.
Assuming John joined Mr. A to run Bed Linens Online as partners. They each withdraw $1,000 from the business and put it into their savings for their children’s college education. An accounting report on the partnership’s financial statement would show that the business has $2,000 less cash.
Personal property and owner’s liabilities are not included in business financial statements. Suppose Mr. A purchased two computer games, one for his personal use and the other for Bed Linens Online. Only the computer for business use must be recorded in the company’s books.
It is also required under this concept that if the owner has more than one commercial firm, the records and financial statements of each must be kept separately. The accounting process is primarily for the company and secondarily for the owner or investor.
Suppose Mr. A, in addition to his personal assets and Bed Linens Online, owns two other businesses, a laundry service and a delivery service. The financial records and statements of the three businesses must be kept separately so that decisions can be made for each of the businesses.
If they are kept in the same set of accounting records, or if the personal activities of the owner are included, it would be difficult to know which business is financially profitable or solvent.