What is the Business Entity Concept? CS Executive

What is the Business Entity Concept? CS Executive

The business entity concept indicates that a business and its owners are two separate entities. Therefore, their financial treatment should not be the same. Under the business entity concept, the business performance of different segments or divisions gets calculated or measured separately. 

In simple terms, this idea suggests that the assets, liabilities, income and expenses of a business are separate from the assets, liabilities, income, and expresses of a business owner. Financial records get maintained separately under this entity concept. 

An example of a business entity is a sole trader or proprietorship. 

All assets, liabilities, incomes, and expenses of a business should be in the name of the business. The business owner can be liable for the business’s liabilities and expenses, but it does not mean that the business’ liabilities and expenses are that of the business owner. 

The business entity concept is very crucial as it helps to measure the performance of a business on different parameters such as cash flows and profitability separate from its owner. It helps in calculating the taxes of the business and its owners separately.

Business Entity Concept Example

Let’s say Mr. X owns a business of garment manufacturing called X Garment Store. To keep his operations smooth and running, he has two employees working under him. Both employees get a salary of INR 30,000. 

Following the business entity concept, he also pays himself a salary of INR 50,000 and reflects that as a salary expense in the accounts of X Garment Store. 

Alongside, he also makes investments in his friend’s startup business which deals in packaged food items. However, he makes those investments from his personal bank account, and it has nothing to do with X Garment Store. Therefore, his investments do not get reflected in the accounts of X Garment Store since that investment does not have any financial impact on his manufacturing business. 

Reasons behind the Business Entity Concept

The Business Entity Concept came to existence so – 

1. Each business entity could get taxed separately.
2. The financial performance and financial position of an entity could get calculated separately.
3. To determine the amounts of payouts/liabilities to/of the various owners, respectively, at the time of liquidation. 
4. To ascertain the assets available in the event of a legal judgment against a business entity.
5. For auditing purposes as an entity’s accounts can not get audited if the records have been combined with those of other entities and/or individuals.

Benefits of the Business Entity Concept

• It quantifies the precise and accurate financial performance of a business in cash flows and profit.
• It facilitates the assessment of every business’s financial position separately on any given day at any given time.
• The clarity of the accounts of businesses apart from their owners or partners does not make it difficult to audit the records.
• Peer company analysis becomes easier since one business can only get compared with another company if the rationale behind their accounts is the same. 

Different Business Entity Types

1. Sole Trader or Proprietorship 

It is the primary and most elementary sort of business entity. The business is run by a single person. Therefore, all the profits earned and losses incurred are that of the sole trader. 

Consistent with the business entity principle, even though one person runs the business, the business and the business owner get considered as two separate entities for all accounting purposes. 

One major drawback of this business type is that since the sole proprietor is the sole owner, the entire liability of the business is that of the sole trader in case the business ends up in losses. 

2. Partnerships 

There are three types of partnerships within the business entity concept. They have been explained below – 

• General Partnership 

It is an agreement between two or more people coming together to start a business. Each partner invests money called Capital to start the company. The profits are shared upon pre-agreed terms based on the capital, skill, and labour they have invested within the business. 

• Limited Liability Company 

Limited liability gives a legal structure for the business where the owners come into a formal agreement to run a company together. These owners are highly-driven professionals who pool in their resources and work towards growing the company. 

A key benefit of an LLP is that none of the owners is personally liable for their assets against the losses of a company. It makes a distinction between corporate accounts and the owner’s accounts. Therefore, the creditors can not be after the owners in case they need their resources back. 

One drawback here is that registering an indebted company may be a long and tedious process.

• Corporation

An article of incorporation forms an organization. The downside of a corporation is ‘double-taxation where the corporation pays tax on its profits and the shareholders also pay tax on the dividends they get.

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