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The business entity concept establishes that, for accounting purposes, the business and its owners are considered separate entities. This separation ensures that the business’s financial activities are distinct from the personal financial activities of the owner.
For example, when an owner invests money into the business, it is recorded as a liability of the business to the owner. Similarly, when the owner withdraws cash or goods for personal use, these withdrawals are not treated as business expenses. Instead, the accounting records focus solely on the business transactions, not the owner's personal transactions.
The Business Entity Concept is fundamental to accounting.
Consider the following example: Mr. ABC starts a business with an investment of ₹200,000. He uses ₹80,000 to purchase goods, ₹40,000 to buy furniture, and ₹60,000 for plant and machinery, leaving ₹20,000 in cash. These assets belong to the business, not the owner. According to the business entity concept, the ₹200,000 investment is recorded as capital, representing a liability of the business to the owner.
If Mr. ABC then withdraws ₹6,000 in cash or goods for personal use, this amount is considered a private expense and not a business expense, and is recorded as "drawings." Thus, the business entity concept treats the business and the owner as separate entities, and any personal expenses of the owner are recorded as drawings.
The significance of the business entity concept includes:
It helps in determining the profit of the business by recording only business expenses and revenues, excluding private and personal expenses.
It prevents the recording of the owner's private or personal transactions in the business accounts.
It facilitates the recording and reporting of business transactions from the business’s perspective.
It serves as a fundamental principle underlying various accounting concepts, conventions, and principles.
Read the next article to learn more about the Money measurement concept.