Business entity concept and areas of applications

The business entity concept explains how owners’ transactions with the business should be treated. In law, a company is seen as a legal entity with the ability to sue and be sued. While this is applicable to only companies and does not include sole traders and partnerships, however, in accounting transactions of entities are separated from those of the owners’ no matter the type of organization.

1. What's the business entity concept?

Also referred to as a separate entity or the entity concept is an accounting term that explains how financial transactions of the business should be treated. The principle states that every business transaction must be treated separately from the owners'. And that an entity must be separated from its owners.

Transactions such as the sales of goods is a business transaction done with a third party. However, when the entity owner decides to take out goods from the entity without making payment this must be treated separately. As a result of the entity concept, terms like Capital/Equity, drawings, directors current account, partners current account, and dividend are accounts created for the owners.

The principle also makes it clear that owners of businesses are not permitted to take money out of it. In company law for example, directors are not allowed to take loans from the entity even if they are shareholders. To do so, there must be a resolution by the board members. But for financial service firms such as banks, directors are allowed to do so based on the Central Bank directive on the single obligor limit of banks.

However, business owners can pay themselves a salary as employees of the firm. Where the owner puts in funds to the business, it is treated differently from when money is loaned to the firm either through friends, relatives, or via banks.

2. Areas of applying Business entity concept

The following are some of the areas where this accounting concept is applied.

2.1 Drawings

This occurs when a owner of a sole proprietorship withdraws either goods or cash from the business. Instead of treating it as an expense in the entity's books, a drawing account is opened to post those transactions.

2.2 Partnership current account

The account shows the partners transactions with the firm. If a partner withdraws cash or goods, they are posted here. More so, if the partner receives an interest from the entity it goes to this account.

2.3 Directors current account

This is used when a director provides funds to the entity. Therefore, it is a liability account. And shows the interest of the directors to the company. However, this money can be repaid by the entity to the director(s).

2.4 Equity

Equity is the funds contributed by shareholders. For sole traders and partnerships it is referred to as capital. This contribution of the owners represents their interest. Therefore, it is treated separately from other books of accounts of the entity.

2.5 Dividend

Dividend is the money agreed to be given to shareholders as a return for the funds they provided to the business. In the financial statement, dividend is not included as expenses in the statement of profit or loss since it does not reflect the activities carried out by the company.

2.6 Changes in owners Equity

To show the movement of funds made in favor of the owners, a statement of changes in equity is prepared and included as part of the items in the financial statements. The International Accounting Standard (IAS) number 1 specifies that businesses should include this statement in compliance with the business entity concept.

4. Conclusion

As you have read, the business entity concept helps separate the transactions of the owners from that of the business. It is an important concept that helps in building transparency of financial transactions of the entity.