According to the idea of business entities, a business is an independent entity. It should be viewed as a separate individual who is different from its owner, in other words. The phrase also goes by the name of separate entity and economic entity concepts.
According to the idea of business entities, businesses and their owners are considered to be different legal entities for the purpose of accounting procedures. Accountants should only keep track of the business’s affairs, not the owners private affairs.
How does a Business Entity work?
Business entity is made up of numerous people and entities. They consist of the proprietors, partners in partnership firms, or shareholders in corporation, depending on the situation. Many business ventures are managed by people other than their owner, despite the fact that other businesses, particularly partnerships and proprietary concerns are controlled by the business owners.
The hierarchy of managers may starts with the chairman, managing director, or member of the board of directors and extend all the way down to the sectional heads chosen to oversee particular business operations.
In accounting, the business entity concept prevents personal and business expenses from becoming entangled, interfering in determining the correct taxable information. Any money moving to or from the company should be recorded in a separate accounting journal to avoid confusion.
Examples of Business Entity Concept:
- Owners Draw: You decide to take money out of your company to pay for your child tuitions because you own the company. Such withdrawal counts as an expense for the company because it permits a capital loss to finance a personal expense. To indicate that the transaction is for personal use, it must be written as an owner’s drawing. Paying yourself a salary, which would regard as regular wages, is not included.
- Loaning Money: If you want to lend personal funds to you firm, that will be viewed as a risk for the business. The loan amount will be regarded as a debt that must be repaid in accordance with the terms of the loan, with penalties for late payments. Usually, it can be done with the help of an attorney.
Contributed Capital: Managing two accounts, one for business and one for personal use can be challenging for small business owners. It would be regarded as an instance of contributed capital by the owner if you unintentionally use your credit card to pay for a business item, such as office supplies.
Let’s look at this situation,
If the company owner pays RM 5,000 in tuition for their child’s tuition fees and RM 3,000 rent of his shop, the accountant will only record the RM 3,000 in rent. The reason for this is that, in contrast to school fees, it is a business-related subject.
All different kinds of commercial entities, such as sole proprietorships, partnerships and joint-stock companies adhere to this idea. It is only observed when recorded in the books of accounts for partnerships and sole proprietorships.
Conversely, the idea is adhered to in full by joint-stock companies. Particularly, there is no legal affiliation between the Company and the Members. Analysis of accounting data is now very simple and goal-oriented thanks to this technique.
Importance of having business entity concept:
- The idea of a business entity is crucial for analyzing a specific company’s performance in terms of profitability, cash flows, etc.
- It aid in evaluating the individual financial standing of each organization as of a given date.
- If a company’s records are mixed together with those of other businesses or people, it becomes difficult or impossible to audit them.
- The idea makes sure that every company entity is taxed differently
- Business groups frequently use the notion of a business entity. A business would not able to compare its financial performance to that of its competitors if it ignored this idea.
Businesses primarily exist to produce services and things at low cost and then exchange them for profits. However, regardless of whether they are an owner, CEO or employee of the company, the profits grained, or any losses incurred do not accrue to any single person.
For this reason, the firm as a distinct entity must be linked to the accounting idea of a business entity. Consequently, a corporation is distinct from its owners as a legal entity. All transactions must expressly refer to the company’s own undertakings in order to be valid.