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Business Entity Concept

Last updated date: 09th Apr 2024
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Business Finance and Owner’s Finance is Not Equal – Business Entity Concept

In the study of accountancy, we come across the term ‘Business Entity Concept’. This concept is being taught to the students in the initial study itself. The business entity concept elevates the responsibility of the owner whenever the business capital is utilized for personal usage. This concept compels the business and the owner to be very much responsible for their separate financial obligations. Thus, this principle is also applicable to the owners of multiple companies.

In this context, we are going to discuss it in the same context. We are going to answer questions like “What is Business Entity Concept?, and we will know about the examples of the same. 

What is the Business Entity Concept?

Under the business entity concept, a business holds a distinct and separate entity that is quite separate from its owners. " This concept holds the business as an enterprise or an institution which has its own right separate and distinct identity from the parties who generate the funds" Example of such an entity can be a sole trader or the proprietorship.

In the business entity concept, it is stated that the transactions which are associated with a business must be recorded individually which will be separate from those of its owners or from other types of businesses. For this concept, the usage of a separate accounting record for the business is initiated. In this record, any transaction or record of assets or liabilities of any other entity or the owner is totally prohibited. 

With the help of this concept, the records of any other entities are kept separate and hence there is no chance of mingling the both

Business Entity Concept Example 

  • Rs. 1,000 was distributed to its sole shareholder. This is actually a reduction in the amount of equity from business and 1000 comes under the taxable income to the shareholder. 

  • The owner of MNT Ltd. personally acquires an office building, and he rents the space in it to his own company MNT at Rs. 50,000 per month. This rent expenditure comes under the purview of the business expense. Thus, the company will bear it and this is taxable income to the owner. 

  • The owner of a business, named Mr. David, loans Rs.100,000 to his company. This is being recorded by the company as a liability from the owner, and by the owner as a loan that is yet to be receivable from the company.

Further, we will provide more business entity concept examples. 

Why is the Business Entity Concept Being Applied?

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The separate business entity concept is to be applied to every kind of business, like the sole proprietorship, partnership, and also corporation-type business. This is done to retain the financial integrity of those who are together involved in this company. The purpose of this concept is to ensure that the business’s own financial statement will reflect the performance of the company. This will also allow the shareholder and other stakeholders to chalk out its own financial performance and its positioning in terms of finance.

In the field of accountancy, the business entity concept will prevent the personal and the business expenses from being mixed up, which can actually interfere with the capability of determining the correct taxable information in that manner. Any money that is moving to or from the company is to be recorded in a separate accounting journal altogether in order to avoid any confusion.  

What is the Need for the Business Entity Concept?

The business entity concept in the process of accounting proves to be of great importance because of the following reasons:

  1. The business entity concept is generally a separate type of measure that will record the performance of a particular business in terms of its own profitability and its cash flows etc.

  2. This concept helps in assessing and analyzing the financial position of each and every business on a separate basis on each transacted date.

  3. It will be an acute problem to audit the records of a business if they were mixed together and not maintained separately. 

  4. This concept will ensure that each of the business entities is taxed separately and one single loss-making entity.

  5. The implementation of the business entity concept is very much common and thus general among many business organizations. Thus, if a company ignores this very concept, they would not be able to compare their financial performance with that of the others who are in the same industry.

Limitation of Business Entity Concept

There are also some disadvantages related to the Business Entity Concept. The limitations are discussed as under:

  • The true value or the net worth of an investor is actually not visible as the business is separate from its owners.

  • When the owner lends money in the business, he is required to see it as a loan thus he needs to repay himself back the loan amount, which is redundant according to some critics.

  • The person working behind the business is its owner, hence with this concept the reputation of the business is noticeable and not the owners. 

Business Entity Concept with Example – More Examples For a Clearer Understanding  

Example 1:

Mr. Akshay has acquired a floor which has 3 halls for around Rs. 50,000 per month. He uses these two halls for the purpose of business and one for his own personal use. According to the business entity concept, only the rent of the two halls will be his valid expense of the business.

Example 2:

The owner of a company lends a loan to his own company. This would then be strictly recorded in the books of the company as the company’s liability which has to be paid back to the owner by the business.

Did You Know?

  • The main motive of implementing the business entity concept is for the purpose of honest taxation by the owners. As we know, each business is taxed separately, thus the owner cannot show his income under a loss-making business of his own to escape from the realm of taxes. 

  • The business which is mostly affected by separate entity type business is Sole Proprietorship. 

After learning and knowing in-depth about the business entity concept with its example, now it must be clear for the student to understand why a business uses separate recording books for his business and for his personal use. This concept is universally accepted and is rigorously followed in all types of business. 

FAQs on Business Entity Concept

1. Name some business entities that will follow this concept?

The types of entities are as follows:

  • Sole Proprietorship

  • Partnerships

  • Corporations

  • LLCs (Limited Liability Companies)

  • LLP (Limited Liability Partnerships)

2. Business Entity Concept is not applicable to which kind of business?

This concept is applicable to all kinds of businesses. Regardless of its operations, this is mandatory that every business must apply the business entity concept.