The Economic Entity Principle in Accounting

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Hira Aziz
Pakistan

The Economic Entity Principle in Accounting

The economic entity principle is one of the fundamental principles of accounting. It separates the owner from the business as two different entities:
The owner
The business

According to this principle, business transactions must be treated separately from personal owner transactions. In the accounting records of a business, only those transactions are recorded that have a particular business effect and transactions that are not relevant for a business must be treated separately. Generally Accepted Accounting Principle (GAAP) considers the owner and its business as two different persons. A business has a separate legal existence. Thus, GAAP requires preparing all financial statements based on the economic entity concept.
Corporations, partnerships, and sole proprietorship are three different forms of business entity. All these business entities, regardless of their structure, require applying the economic entity principle for their business transactions. This is so for several reasons:
  • EVALUATION BY INVESTORS AND GOVERNMENTS who evaluate business performance and make their decisions based on available financial statements.
  • AUDITORS AND STAKEHOLDERS: It is crucial for validity and usability of accounting information for auditors and all stakeholders.
  • TAXATION: Every business entity is taxed on its taxable income while owners are taxed separately.
  • LIABILITY: The separate entity has a separate liability that owes limited liability to the owners.
  • LIQUIDATION: It helps in determining the payouts for owners during the liquidation process.

Examples of the Economic Entity

  • Assume that Mr. John, owner of the ABC Company, purchases equipment and a car worth 56,000 and 4,000 respectively from XYZ company for personal use and record the transaction in the business accounting records as below:.

    Here, we can see that John is violating the economic entity concept by recording these expenses as a business expense. According to the economic entity principle, these expenses should be considered as the owner's personal expenses and must be recorded as the owner's drawing in the balance sheet.
  • Assume that David is the owner of a construction firm. David lends 10,000 to the company. Here, the loan should be recorded as a liability by the company and must pay back to the owner. The owner should record it as a loan receivable.
  • Assume that Tom, son of the owner of the ABC Company, has recently started his own business. He ordered his accountant to merge financial transactions of these two business entities in a single accounting software file. Here, we can see that Tom is violating the economic entity concept by recording the business transactions of two different business entities in a single accounting software file. Thus, according to the economic entity principle, the accountant should prepare two different accounting software files for recording business transactions of two different entities in their respective file.
Sources
Mitchell Franklin, Patty Graybeal, Dixon Cooper(2019), "Principles of Accounting Volume 1 - Financial Accounting"
"Entity in Accounting", Corporate Finance Institute

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