The business entity assumption is an accounting principle that makes a legal distinction between the transactions carried out by a business and the transactions of the owner. It might also sometimes refer to the separation of different divisions in a company. Each unit maintains records of its operations and is responsible for its transactions.
This does not only apply to the larger entities but also the smaller enterprises as well. A sole proprietor should keep his personal transactions separate from business transactions.
This assumption is also valid for businesses with multiple operations. For example, a company might have two businesses – an airline and a hotel. It is expected that the company would present the financial statements of these two entities separately so that the true value of the company can be ascertained.
Importance of the Business Entity Concept
The business entity concept is important for a variety of reasons including the following:
- Business performance of various segments or divisions is measured separately.
- Audit becomes an easier process if separate financial records are maintained. If the records of different business units were intermingled, it would be a nightmare for the auditors to perform their evaluations.
- Each business unit is taxed separately.
- If a company violates this principle, comparing its financial performance of it with others in the industry would become difficult.
It is important to note the difference between limited liability and the business entity principle.
Limited liability is a type of legal structure for a business where the owner’s personal assets are not at stake in case the company makes losses and needs to pay its creditors. In other words, it creates a legal distinction between the owner and the business in a way similar to what the business entity assumptions do.
However, there are a few notable differences between the limited liability and the business entity principle:
- First, the business entity principle applies to all types of business entities including sole traders. The limited liability does not apply in the case of a sole trader.
- Second, Limited liability is a form of legal protection. Whereas, the business entity principle achieves the separation of only the financial transactions of the owner and company.
Types of Business Entities
The most common types of business entities are:
This is the simplest and basic form of a business entity. It is run by an individual for his own benefit and he does not have to share his profits with anyone else.
As per the business entity assumption, the financial transactions of the owner and business are treated and accounted for separately. This means that the owner’s personal assets and liabilities do not have to be included in the records of the company.
However, the sole proprietorship does suffer from having unlimited liability. This means that in the case of a company going bankrupt, the owner will be personally liable to pay the dues of the company from his personal assets. This is because the business entity principle does not talk about the separation of any legal issues, it merely requires that the financial transactions of the owner and company are recorded separately.
A partnership can be of two types – a general partnership and a limited liability partnership.
A general partnership is an agreement between two or more people coming together to run a business. Each partner has a certain portion of capital invested whether it is in the form of money, skill, or labor, and then shares in the profits and losses as per agreed upon terms. A general partnership is similar to a sole trader in terms of having unlimited liability, which means that the partners are personally liable for the debts of the company.
A limited liability partnership does away with this problem. The owners and the business entity are legally two separate entities. Therefore, if a business is bankrupt, the partners do not have to lose their personal possessions as in the case of a general unlimited liability partnership.
Limited Liability Company (LLC)
These are business entities that combine the pass-through taxation benefit of a sole trader with the limited liability benefit of a corporation. Due to the high flexibility in its structure, registering an LLC is a long and arduous process.
An article of incorporation is used to register and form a corporation. The shareholders have limited liability and the employees enjoy tax-free benefits such as health insurance. Corporations have a perpetual life, which means that ownership can be transferred to future generations by the existing shareholders.
The downside of a corporation is that they are subject to what is called “double taxation”. The first income tax is paid by the corporation on the profits it makes, and the second tax is paid by the shareholders on the dividends they receive. Another drawback of a corporation is the high cost it takes to set them up and that they are usually more regulated by the government.
Examples of Business Entity Concept
Here are some examples of when this concept can be violated:
- Tom uses his company’s credit card for personal expenses such as laundry and dining out. He argues that these expenses are business-related as he wears clean clothes to his office and has a meal or two in between his meetings. As per the business entity principle, these are not business expenses and should be accounted for as owner withdrawals or drawings from the company.
- Bob currently owns a donut shop and is considering buying a pizza shop that someone else has opened next door. After Bob goes through the acquiring process, he merges the financials of both entities into one single QuickBooks file. Bob is clearly in violation of the business entity principle here as he has not treated both the donut shop and pizza shop as separate entities. As per the stated principle, the correct way would be to recognize that both entities are separate and their financial transactions should also be accounted for separately.
1. What is a business entity?The business entity is the distinction of where the financial transactions for a single company are recognized on paper, whether it belongs to an individual or another business.
2. What are the types of business entities?There are four types of business entities – sole trader, partnership, limited liability company, and corporation.
Sole trader: This one is the simplest as it follows the pass-through taxation principle. The sole trader has unlimited liability and pays taxes on business revenues and personal expenses separately.
Partnership: A partnership is an association of two or more people to conduct a business and share in its profits and losses.
Limited liability company: The owners and the business entity are legally two separate entities, which gives you limited liability for the debts and actions of your business.
Corporation: A corporation is a separate entity from its owners, which means that the shareholders have limited liability for the company's debts and obligations.
3. Why is a business entity concept important?The business entity concept is important because it keeps the business and its owner separate.
This allows governments to regulate businesses more easily as they are not controlled by their owners. This makes owning a business easier as an owner does not have to pay taxes on all of their personal income.
The downside, however, is that owners may be held liable for any business debt or legal issue that arises, therefore owners must be very careful about what they put their names on.
4. How do you change your business entity type?Each type of business entity can have different methods for changing its type.
For a sole trader, it is as simple as making an amendment to your governing legislation that allows you to become a partner in the business instead.
For partnerships and limited liability companies, it would be similar to doing the same steps but with another person or people.
There is a different process for limited liability companies and corporations. Limited liability companies need approval from the governing legislation while corporations require more formal documents on top of that, such as an election of directors and changes to the authorizing resolution. There are also more filing fees for both of these types of business entities.
5. Which business entity has the greatest liabilities?A corporation has the greatest liabilities because while it is a separate entity, its liability can extend to the shareholders if it goes into bankruptcy.
As for limited liability companies, neither of them are separate legal entities but both have some degree of separation depending on the size of the company and how much influence one owner has over another.